Owners of SUVs often appreciate their cars most when they leave smooth highways for rough gravel country roads. In investment, highly diversified portfolios can provide similar reassurance. In blue skies and open highways, small cars might cruise along just as well as sturdier SUVs but the real test of the vehicle occurs when the road and weather conditions deteriorate. That’s why people who travel through different terrains often invest in a SUV that can accommodate a range of environments without sacrificing fuel economy, efficiency and performance.
Structuring an appropriate portfolio involves similar decisions. You need an allocation that can withstand a range of investment climates while being mindful of fees and taxes. When certain sectors or stocks are performing strongly, it can be tempting to chase returns in one area. But if the underlying conditions deteriorate, you can end up like a motorist with a puncture on an isolated road without a spare. Likewise, when the market performs badly, the temptation might be to put everything in cash. But if the investment skies brighten and the roads improve, you risk missing out on better returns elsewhere.
One common solution is to shift strategies according to the climate. This is a tough and potentially costly challenge. It is the equivalent of keeping two cars in the garage when you only need one. You’re paying double the insurance, double the registration and double the upkeep costs.
An alternative is to build a single diversified portfolio. That means spreading risk in a way that helps ensure your portfolio captures what global markets have to offer while reducing unnecessary risks. In any one period, some parts of the portfolio will do well. Others will do poorly. You can’t predict which. But that is the point of diversification. Diversification increases the reliability of outcomes and helps you capture what the global markets have to offer. Add discipline and efficient implementation to the mix and you get a structured solution that is both low-cost and tax-efficient.
Remember you can never completely remove risk in any investment and even a well-diversified portfolio is not bulletproof.