Key Investment Insights: Smoothing the Investment Ride

September 4, 2014
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Welcome to the next installment in our series of Key Investment Insights.

In our last piece, “Managing the Market’s Risk,” we described how diversification can minimize risks and help you better manage the risks 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 investment goals.

Diversifying for a Smoother Ride

Like a bucking bronco, short-term market returns are characterized more by periods of wild volatility than by a steady canter. As any rider knows, regardless how high you jump, if you’re tossed out of the saddle, you’re going to get left in the dust.  Here’s how diversification can help you tame that particular beast.

When you crunch the numbers, diversification is shown to help minimize the leaps and dives you would otherwise have to endure along the way to your expected returns. Imagine, if you will, several rough-and-tumble, upwardly mobile lines that represent different kinds of holdings. Individually, each line represents a bumpy ride; however when bundled together the upward mobility generally remains, but the jaggedness can be smoothed out (although it is never completely eliminated).

DFA Investment Principles Slide 1

 

 

 

 

 

You can click on the graph for a better view.  Then click back to continue reading.

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If you’d like to see a data-driven illustration of how this works, check out this post by CBS MoneyWatch columnist Larry Swedroe, “How to diversify your investments.”

Covering the Market

Different market components respond differently to price-changing events; while one investment might zig on some particular fundamental news, another investment might instead zag. And that is the reason why diversification works! Instead of trying to move in and out of favored components, your goal should be to remain diversified across a wide variety of them. This increases the probability that while some of your holdings might underperform, the others will outperform, or at the very least, hold their own.

As is often the case with investing, the results of diversification aren’t perfectly predictable nor are they guaranteed.  But by positioning yourself with a blanket of coverage for capturing possible market returns, wherever and whenever they may occur, you will have gone a long way toward replacing guesswork with a coherent, cost-effective strategy for managing your desired outcome.

The chart below illustrates that concept.  After viewing a color-coded layout of those market factors which have been the winners and those that have been the losers over the past 15 years, it’s pretty clear that the only discernible pattern is that there is no discernible pattern.

DFA Investment Principles Slide 2

 

 

 

 

 

 

 

 

You can click on the graph for a better view.  Then click back to continue reading.

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Your Takeaway

Diversification can provide you with wider, more manageable exposure to the market’s long-term expected returns, as well, perhaps, a smoother ride along the way. More important, it eliminates the need to try to forecast future market movements, which in turn helps to reduce those nagging self-doubts that tend to throw so many investors off-course.

Thus far in our series of Key Investment Insights, we’ve introduced some of the challenges investors face and various ways that they might be overcome. Next up, we’ll take a closer look at some of the mechanics of solid portfolio construction.   Click here for the next post.

 

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