You’ve Got to Steer Your Boat

One of the Great Truths of Investing is that diversification is the key to avoiding roller-coaster returns in your long-term portfolio.

That “Truth” looks more and more like a myth.

I’m not saying diversification won’t smooth out returns in some cases. It will. That’s certainly true in a stock portfolio. Owning 12 to 20 stocks across different industries has been proven to result in less long-term volatility than owning only a few stocks. The same goes for mutual funds.

But when it comes to asset classes – stocks, bonds, real estate, et cetera – diversification alone hasn’t offered protection. Especially during periods of market turmoil, divergent asset classes often have moved together rather than in different directions.

I’ve been thinking about this phenomenon quite a bit as we approach a period of rising interest rates, which could increase U.S. stock market volatility. Will bonds, REITs, emerging markets or other asset classes work as a way to protect portfolios from a decline in U.S. stocks? This morning an interesting Bloomberg article delves into the numbers, finding that correlations between different asset classes — say, the S&P 500 and the Dow Jones U.S. Select REIT Index – aren’t as low as you might assume. In fact, they rose considerably during the financial crisis.

Check out the article; it’s a fascinating read. But if you don’t have time and want the bottom line as we see it, it’s this: you’ve got to steer your boat.

It sounds corny, but you really are the captain of your financial boat, and it needs your hand on the tiller. Sure, when skies are sunny and the current is moving fast in the right direction, you can sit back, sip Maker’s on the rocks and enjoy the ride.

But guess what? The easy ride never lasts forever. You can’t count on good weather or calm seas. Successful investors pick and choose individual investments carefully, usually moving in when the crowd moves out and vice versa. Parking money in general baskets representing several asset classes is a lot better than relying on a single stock or mutual fund, or stowing it away in the mattress. But it won’t protect you in a rocky market.

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