Investment research has long shown that an investor does best by holding investments in a variety of different assets whose returns are not closely correlated. This type of investing, known as “asset class investing,” has plenty of support in academic research and in practice. In general, a well-diversified asset-class portfolio behaves in a more stable fashion over time and, given enough time, delivers a return that is higher than most or all of its components. That’s because during any time period certain components go up enough to pull up the performance of the whole portfolio and to make up for declines in other asset classes.
Such a portfolio also takes a lot of the guesswork out of investing. The investor does not have to make risky decisions on when to invest in individual asset classes. Such decisions are dangerous because wrong moves can be very costly. By holding a widely diversified portfolio you are assured that wrong moves will not severely damage the entire portfolio. You also have a very good chance that at any one time you will hold one or more asset classes that are doing well. Unfortunately, the majority of investors do not hold portfolios composed of many asset classes.
Author and investment manager Roger C. Gibson, who wrote the investment classic “Asset Allocation,” has identified three reasons some investors don’t invest wisely. First, they don’t understand the full power of diversification. Many investors intuitively understand that a diversified portfolio will be less volatile than a non-diversified portfolio. But they also intuitively feel the diversified portfolio will have inferior returns, because non-performing assets will negate the big wins by those assets that are climbing. In the short term, this will often be true, but in the long term, multiple asset class portfolios usually beat most or all individual asset classes. Diversification not only reduces risk but it improves long-term returns.
A second reason investors stumble is their belief that someone, somehow must be able to forecast returns. If that is true, one need only make the correct forecast and then put everything into the asset class that will do best in the future. They get plenty of support from Wall Street and the media, which constantly publicize “star” investment pickers and strategists who beat the markets. Again, this is a mistake. Gibson says the evidence on actual returns on money managers shows that few, if any, consistently even match the market’s returns, much less beat it.
The final reason for lack of diversification involves the reference frame within which most investors judge their results. For American investors that frame is usually “the stock market.” And by “stock market” they generally mean the big stocks that dominate the market and whose returns are reflected in the Dow Jones Industrial Average or the Standard & Poor’s 500 Index. When the U.S. market is doing badly, a diversified portfolio holding foreign stocks and other assets often looks good. But in those inevitable years when the S&P 500 beats everything else, the diversified portfolio doesn’t look as good. This is a big problem for investors who check the daily market averages or compare portfolios with neighbors at cocktail parties, Gibson says: “There is pain in being different!”
Investors who want to do well over the long term with less risk should use a diversified asset class portfolio. They should also acknowledge the potential cognitive roadblocks to sticking with their portfolio.
