I’ve been finding many people are becoming increasingly confident in their ability to manage their own investments. Somewhat surprisingly, many of these people are picking individual stocks and aren’t diversifying outside of stocks. In other words, 100% of their portfolios are invested in stocks, most often U.S. stocks exclusively. The level of overconfidence appears to be growing which is fairly typical for a mature stock market cycle, especially one that has lasted for as long as the current one has.
Overconfidence is one of those inherent human biases that can distort our ability to properly construct and manage an investment portfolio. The 100% allocation to U.S. stocks has worked extremely well over the past several years as stocks have moved higher and volatility has been very tame. However, this type of environment isn’t likely to last forever. Most, if not all, of us won’t see the change coming and will get caught flat footed when volatility picks up and stocks change course.
Based on our inability to predict the future or identify key inflection points, having a well-constructed portfolio that is diversified across asset classes, geographies and investment strategies is essential. This portfolio may not be up as much as the market in boom times, but it won’t be down as much either during bust times, leaving more of your capital to grow and compound over time.
A diversified portfolio
The 60/40 portfolio is the starting point for most diversified portfolios. It consists of 60% stocks and 40% bonds. A lot of the stock-centric investors I speak with don’t like bonds because the yields are so low. They often don’t understand that there’s also a capital appreciation element to bonds as well as interest rates fluctuate. While bonds may not be sexy, they can provide much needed diversification and volatility dampening. Additional assets classes such as real estate, precious metals, commodities and other alternative asset classes can also be added to an asset class to provide further diversification.
The figure below shows the difference between a portfolio invested in 100% stocks and a balanced portfolio consisting of 60% stocks and 40% bonds for a 43-year period. While the 100% stock portfolio gained nearly 1% more per year over the time frame, the volatility was substantially higher as evidenced by the worst 1-, 3-, 5- and 10-year return periods. The only way an investor would have achieved the higher return is if he/she was able to stay invested 100% in stocks throughout the entire period, which included Black Monday, the dot.com crash and the Great Financial Crisis. Studies have shown that most of us would have failed to stay invested as we tend to chase performance and get shaken out during large drops in the stock market.
The chart below shows the difference between a 60/40 portfolio and an 80/20 portfolio over a 10-year period ending 12/31/2019. Specifically, the chart is addressing a portfolio that starts out as a 60/40 portfolio but drifts to an 80/20 portfolio due to out-sized stock returns relative to bonds. Rebalancing is important but I’m not including this chart here to drive home the importance of rebalancing. I’m including it here because it re-enforces the point I’m trying to make in this post about properly diversifying. A portfolio consisting of 80% stocks and 20% bonds has higher volatility, a higher average loss, a higher average drawdown and a higher maximum drawdown. All of these metrics are at least 35% higher than a 60/40 portfolio over the reference time period, which admittedly is short.
To clarify, there isn’t anything that is particularly magical about a 60/40 portfolio except that it is the current poster child for diversified portfolios. The key element from my perspective is that most people feel they need to have a massive portfolio allocation to stocks. However, most don’t have the emotional and psychological ability to stay invested during the most volatile and gut-wrenching periods for stocks. As a result, they tend to get out at the worst times and if they get back in, they get back in pretty close to the worst time as well. Having a portfolio that lets you sleep at night and significantly minimizes you from self-destructing is more likely than not the optimal portfolio. Sure, we all want to make a lot of money. However, our desire to not lose money is probably stronger. Additionally, we’re not hardwired to handle the chaos of the stock market, especially during volatile times. Our emotions tend to get the best of us leading to sub-optimal investment decisions.
As Ray Dalio says, “Diversifying well is the most important thing you need to do to invest well.”