By Micah Porter, CFA, CFP®
Aside from controlling spending and saving, how you invest is the most important factor in meeting your financial goals. You can spend a great deal of time and effort refining your investment process and beliefs and managing your portfolio. Much of the standard advice holds true: diversify your portfolio, keep costs low and understand portfolio risk.
There are also a number of things I’ve learned that have been extremely helpful but are not common knowledge. Here are two of the most important lessons I've learned about investment management after 15 years of experience:
The Diversification That Matters Most
Diversification works, but not often like you think it does. Most investors associate diversification with reducing losses in sharp market downturns. While it’s true that high-quality bonds typically do hold their value in a bear market, diversification among equities and other riskier instruments typically don’t provide much protection in a sharp market downturn. (To learn more, see: Diversification: Protecting Portfolios From Mass Destruction.)
As investment professionals put it, the only thing that goes up in a bear market is correlation - meaning that in times of market crisis, most asset classes move in concert. Over the medium to long-term however, asset classes, particularly equity asset classes, are less correlated. For example, domestic equities markets can outperform overseas markets for an extended period, as well as vice versa.
There is no reliable indicator showing when an asset class is apt to outperform or underperform, but diversification provides exposure to both outperforming and underperforming assets, thereby achieving an average return in line with plan needs. To mitigate losses during bear markets, the diversification that matters most is between stocks and bonds, and particularly high-grade bonds. Over the medium to longer-term, diversification among equities is important in achieving longer-term return goals.
A Realistic Time Frame
Have a realistic time frame for investments you choose. All asset classes will at some point underperform and that underperformance can last for an extended period. As an example, we tend to lean towards a value approach, as a great deal of evidence shows that value investments tend to outperform growth in the long term.
Value investments are investments that are purchased because the share price is viewed as below what the investors believe the shares are worth (known as their intrinsic value). Growth stocks, on the other hand, are stocks of companies that are expected to grow rapidly. Their share price may be greater than what the company is worth at the present time, but the belief is that rapid growth will make the shares a bargain in the long run.
Over the short term, and in fact over a number of years, value stocks can and have underperformed growth stocks, leaving investors to abandon value stocks as underperformance dragged on. Periods of underperformance is the norm for actively-managed mutual funds as well.
In fact, a study done some years ago showed that even for funds with high ratings over the long term, periods of underperformance of three years were quite common. Investor lesson: Understand past periods of underperformance to set reasonable expectations for your investments, otherwise you run the risk of abandoning investments, locking in underperformance and missing subsequent periods of outperformance.
Investment management is complex, but understanding how diversification fits within your portfolio and how patient you should be with your investments will help you build a successful portfolio and reach your financial goals. (For more from this author, see: What I Wish a Financial Planner Had Told Me.)
This article was originally published on Investopedia.