Why bother to diversify your investments across a range of asset classes – such as stocks vs. bonds, large- vs. small-company stocks, and U.S. vs. international holdings? Wouldn’t it be nice to instead hold mostly the best, top selections in your investment portfolio?
Of course it would. It would also be nice to hold a $100 million winning lottery ticket. But just as the lottery is no place to invest your life’s savings, neither is speculating on the razor-thin odds that you can consistently handpick which stars are next in line to shine.
Think of it like this: It’s common knowledge that past outperformance does not predict future investment success. By instead building a broadly diversified portfolio covering a range of asset classes – and sticking with it over time – you’re always already invested wherever the next big run is about to be.
Of course, it stands to reason, by spreading yourself across multiple asset classes, you’ll also always be invested somewhere that isn’t going to do as well.
This degree of built-in disappointment might convince some investors to abandon diversification, and instead try to “beat the market.” Unfortunately, that circles us back to a harsh reality. You’re then back to relying on slim odds and lottery-like luck, rather than evidence-based reasoning to guide the way.
Here’s a helpful way to think about committing to a mixed-bag (diversified) portfolio:
On a scale of 1-10, with 10 being abject misery, I’m willing to bet your unhappiness with a diversified portfolio comes in at about a 5, maybe a 6. But your unhappiness if you guess wrong on your one and only investment for the year? That goes to 11.
— Carl Richards
By the way, not everyone’s diversified portfolio should look the same. Remember, asset classes that are expected to deliver higher returns also are expected to do so with a bumpier, more volatile ride (which I covered in my last piece). So, while broadly diversifying your investments, you also want to adjust how much of each asset class makes sense for you, based on your financial goals, time horizon and risk tolerance.
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