Get along, little market

3rd July 2019

Welcome to the next instalment in our series of evidence-based investment insights; Get along, little market. To check out the rest of the series, click here.

In our last piece, Managing the market’s risky business, we described how diversification plays a key role in minimising unnecessary risks and helping you better manage those that remain. Today, we’ll cover an additional benefit to be gained from a well-diversified stable of investments: creating a smoother ride toward your goals.

Diversifying for a smoother ride

Like a bucking bronco, near-term market returns are characterised more by periods of wild volatility than by a steady-as-she-goes trot. Diversification helps you tame the beast, because, as any rider knows, it doesn’t matter how high you can jump, if you fall out of the saddle. High or low, you’re going to get left in the dust.

When you crunch the numbers, diversification is shown to help minimise the leaps and dives you must endure along the way to your expected returns. Imagine several rough-and-tumble, upwardly mobile lines that represent several kinds of holdings. Individually, each represents a bumpy ride. Bundled together, the upward mobility by and large remains, but the jaggedness along the way can be dampened (albeit never completely eliminated).

If you’d like to see data-driven illustrations of how this works, check out How to diversify your investments, by financial author Larry Swedroe, or When boring is good investing, by financial author Craig L. Israelsen.

Covering the market

A key reason diversification works is related to how different market components respond to price-changing events. When one type of investment may zig due to particular news, another may zag. Instead of trying to move in and out of favoured components, the goal is to remain diversified across a wide variety of them. This increases the odds that, when some of your holdings are underperforming, others will outperform or at least hold their own.

The results of diversification aren’t perfectly predictable. But positioning yourself with a blanket of coverage for capturing market returns where and when they occur goes a long way toward replacing guesswork with a coherent, cost-effective strategy for managing desired outcomes.

Your take-home

Diversification offers you wide, more manageable exposure to the market’s long-term expected returns as well as a smoother expected ride along the way. Perhaps most important, it eliminates the need to try to forecast future market movements, which helps to reduce those nagging self-doubts that throw so many investors off-course.

So far in our series of Evidence-Based Investment Insights, we’ve introduced some of the challenges investors face in efficient markets and how to overcome many of them with a structured, well-diversified portfolio. Next up, we’ll pop open the hood and begin to take a closer look at some of the mechanics of solid portfolio construction.

Continue exploring the rest of the evidence-based investment insights here.