The recent market correction had all the financial heads talking, especially on CNBC. I read several articles describing interviews with investors who were completely shocked that the markets could drop so suddenly. One said, “I have no idea what to do next.” Such a portrayal of investors and the markets being in a crisis would be funny, if it weren’t so sad.
Even sadder, a lot of investment advisors fall victim to the same crisis thinking, being totally surprised about the move and frantically looking for the “next big thing.”
Wise investors, however, don’t participate in this kind of drama. They expect such market declines and do the smart thing—nothing. Investing wisely is really, really boring.
While the equity markets declined about four percent last week, a portfolio with asset class diversification was down only one or two percent. What is asset class diversification? In addition to the usual asset classes of US and international stocks and bonds, a diversified portfolio will also include real estate, commodities and natural resources, market neutral funds, junk bonds, and Treasury Inflation Protected Securities (TIPS).
I’ve heard many investment advisors bemoan the terrible losses their clients suffered between 2000 and 2003. This is in stark contrast to my experience that investors who were diversified among asset classes lost nothing.
Yet polls have shown that three-fourths of financial planners don’t practice asset class diversification with their clients. Planners say it is hard to get clients to stick to an asset allocation plan when the markets are moving strongly up or down. Clients react with fear and even panic to that much volatility in their portfolios.
If a portfolio is well-diversified, most of that roller-coaster volatility is eliminated. Clients don’t panic, because they have no reason to. In 25 years of investment advising, I have had only four calls from panicking clients: one during the 500-point one-day drop in October 1992, one during the Asian meltdown in 1998, one on Sept 11, 2001, and one last week. I have absolutely no problem in getting clients to maintain an asset allocation plan.
One reason for this is my consistency in practicing real asset class diversification. By now, most of my clients understand that it works. A second reason is education. I spend a lot of time educating clients about the principles of diversification, expected asset class returns, volatility, and, yes, standard deviations.
The result of good investment education is that you will have reasonable expectations. You will understand there is no way your portfolio will return more than 10% over a long period of time. You will understand that it is normal for a portfolio with an expected long return of 7% to have annual returns anywhere between -15% and 25%. The last five years have seen diversified portfolios produce average returns of 10% to 15%, well above our expected long term return of 7%. Some sub-standard returns are to be expected in the future. When you know that a -5% return one year is as normal as a 15% return the next year, you don’t panic. You don’t make “the big mistake,” which is selling low and buying high.
So, when it comes to investing, give yourself a break from the drama of the Dow. Make “boring” your goal. Educate yourself, and diversify your portfolio among at least five asset classes. If you hire a financial planner, find one who actually practices asset class diversification. Then, whether you’re investing on your own or working with a planner, you can relax. You won’t need to run frantically for shelter whenever you hear, “The Dow is falling!”