Does diversification work?
For years finance professors preached diversification as “the only free lunch,” touting its ability to reduce a portfolio’s risk while maintaining expected return. After all, if a portfolio is divided up among different countries, asset classes, and companies, then what drives one down is less likely to give everyone grief.
That was the theory, anyway.
During the financial crisis, everything fell. A global credit crunch led to recession and fears of a global depression. The only asset that didn’t fall was gold, and even it fell for a while. Critics talked of “deworsification,” because there was no safe haven.
But this misses the bigger picture. The point of investing isn’t just to control risk. It’s also to create wealth. In the end, if you can be patient and you want to keep your money safe, watching it double is a good way to protect it from a crash that might cut its value in half.
In the short-run, the pain of market panics is fairly well distributed. Short-run returns reflect investor sentiment much more than economic fundamentals. Keynes described it as a beauty contest in which the judges vote on who the other judges think will win. But in the long run economic performance becomes much more important. That’s because due to the magic of compounding, earnings 20 years forward dwarfs anything else.
In the long-run, country-specific economic performance is the most important factor. But we don’t know what the future will bring. Which is why it pays to diversify.
Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!
Follow me on Twitter @GlobalMarketUpd