Diversification beats forecasts
Joel Dresang: Brian, here we are in January, another year beginning, all sorts of prognostications and forecasts of what the investment markets are going to do. You sort of say take all this with a big grain of salt – and make sure you’re diversified.
Brian Kilb: You know, Joel, I think one of the things that challenges investors, one of the things that makes people not so good at this sometimes is they base their investment decisions on predictions – economic forecasts, predictions of the markets. What we know is markets are very unpredictable.
Joel: So Brian, we can’t rely on predictions. How does diversification help?
Brian: Diversification is the tool in your portfolio that allows you to take advantage of the unexpected good things that happen but also defends you against the unexpected bad things that may occur in market performance.
Joel: And when we talk about diversification, we’re not just talking about putting more of your eggs in different baskets. It’s having different parts moving in different directions.
Brian: Yeah. I think correlation would be the technical answer to your question. Correlation is the relationship in performance between two or more asset categories.
So, what you want in your portfolio is non-correlated assets and negatively correlated assets to diversify your portfolio so that when things don’t go exactly the way you think they’re going to, you have an answer in your portfolio.
Joel: So, at any one point, I’m hoping to see my portfolio rising in value, but at any one point, I should also expect to see part of that going down.
Brian: Joel, by definition, diversification will make sure that there are assets in your portfolio that you’re going to be disappointed in. But it’s those assets that mitigate risk. It’s those assets in your portfolio that balance you over the long run and that will help you in the long run.
We like to say that you can make a lot more money over the long run by losing a lot less in the downturns. And managing risk through diversification is what helps smooth out the path, but also I think enhances your return over the long run.
Joel: Brian, you talk about diversifying asset classes. Can you give an example of how that works?
Brian: Yeah. Let’s talk about a couple of different instances over the last few years where there were abrupt changes in asset class performance. So, in 2006, real estate investment trusts had the best performance of any asset class, but in 2007 had the worst. Similarly, emerging market stocks, in 2008, were at the very bottom of the heap, but in 2009, during the recovery, had the best asset class performance.
I don’t think Joel, that many people would have been able to predict the first-to-worst and worst-to-first performance of those two asset categories, which is why I think it would be important to maintain an appropriate allocation to those asset classes to build a properly balanced portfolio.
Joel: Because you don’t know what’s going to be the worst or the first.
Brian: Yeah. We want to use our knowledge, we want to use our experience, to lean into certain asset classes, to favor the things we think will do better – but never to the risk of being so married to one asset class that if you’re wrong it destroys the overall performance of your portfolio.
Joel Dresang is vice president-communications at Landaas & Company.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Money Talk Video by Peter May
(initially posted Jan. 27, 2015)