Any market dips would be the time to pursue portfolio diversifications
Over the past few weeks, I have been travelling around Asia to share our H2 Outlook: ‘Positioning for a Weak US dollar’.
One thing I kept coming across is an all-or-nothing approach to investing. Such an approach is almost always costly as it leads to much greater volatility in investment outcomes, increases your stress levels and reduces the likelihood of you staying the course and achieving your financial goals – that is, a lose-lose scenario.
I believe this trait stems from focusing too much on things going right and only considering the downside risks after the fact - i.e., when faced with significant losses. Then the conversation becomes very difficult.
For instance, I met a couple who lost a third of their portfolio on one single stock. It had fallen over 90%. The question they had was what should they do now?
Our advice was to accept where we are today, but deep down I understand that the desire to recoup losses is extremely strong in these situations. Indeed, the couple indicated that they had been in similar situations before and had held on and subsequently more than recouped their losses. In one instance, while getting back to the value of their initial investment in the other. The difference was that those two companies were profitable. This time, the company in question is only projected to become profitable in 2028.
Another example was a client who asked us for a view on a blue-chip company which accounted for 45% of his net worth.
Regardless of our view on the two stocks in question, the action for both clients is clear – they should have a plan to reduce their exposure over time. For the latter investor, that should probably be quicker because of the concentration being much higher.
Naturally, the ‘what if the stock rallies sharply after I sell?’ question was raised. Again, this is why we don’t advocate an all-or-nothing approach. Rather, we suggested a plan to gradually reduce any over-exposure to any specific asset over time.
In some ways, this is a mind trick. If you sell partially, and the stock goes higher, you might feel bad that you sold any. Alternatively, you can focus on the still significant holdings which benefit from the rising price (‘at least I did not sell everything’).
If the price goes down, it also allows you to focus on the fact that you sold some.
Committing to a ‘glass half-full’ view of the world helps you make better decisions and sleep well at night. A partial action cannot be perfectly right. But it also cannot be perfectly wrong.
The hard reality is we have to make the decisions before we know the outcome. Therefore, we need to think about the different possible scenarios and make our decisions accordingly.
The outcome is probabilistic. This suggests placing your bets in multiple places rather than putting everything in one basket.
Failing to take a probabilistic approach usually results in highly concentrated positions that will be subjected to greater volatility.
However, if you place your bets on uncorrelated investments that have a greater than 50% chance of delivering positive returns, then you will tend to do well. You will win some and lose some, but in this instance, the strategy keeps you in the game in the short run and allows you to win over the long run.
Meanwhile, the more diversified your portfolio, the greater the confidence you can have that losses will be temporary. Time is also more likely to be a great healer.
Looking at data since 1950, a 60% US equity and 40% US bond portfolio has never lost value on a 5-year time horizon. This does not guarantee a similar outcome in the future, but it gives much higher comfort of staying invested and hopefully even adding to investment on weakness.
Let’s take the example of the equity market. Even if you only had the global equity index in your portfolio, there have only been four times that we had seen a bear market (over 20% decline peak-to-trough) since 1999.
The first two – the dot.com bubble burst and the Global Financial Crisis – were the most severe and took 5 to 6 years before market returned to new highs. However, the COVID bear market was recouped in just over six months and the 2022 inflation-induced sell-off corrected in just over two years.
The lesson we can learn from this is that one should buy into equity market weakness if you have funds on the sidelines.
So how do we stop ourselves from getting into a tricky situation in the first place? It is to think about what could go wrong with any particular investment and what would be the implications on your financial future.
There is nothing wrong with investing in an individual stock, but given you cannot rule out the company going bankrupt, you should size it such that if the holding became worthless, it would not hurt you too badly.
On the other hand, a diversified portfolio has more resilience in terms of lower volatility in different scenarios and an increased probability of full recovery over longer holding periods. This is your through-the-cycle portfolio that you ideally add to when markets go on sale and only sell when you absolutely need the money.
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