This is a sponsored column by 3Summit Investment Management, LLC based in Vienna, VA. 3Summit designs custom, modern investment portfolios and has unique expertise in managing investment risk.
By Dan Irvine | Principal, 3Summit Investment Management
U.S. stocks are generally the highest returning assets in a portfolio and therefore often make up the largest percentage of an investment portfolio.
The problem U.S. stocks present investors is that while historically they generate high returns, they are also very risky and are usually the primary contributor to portfolio losses. Many investors are not comfortable losing 30%, 50% or more of their total assets during market downturns, therefore some level of risk management is required to prevent such large losses.
Conventional diversification seeks to mitigate the risk of U.S. stock ownership by investing in other asset classes including foreign stocks, U.S. and international bonds, commodities, real estate and many others. The investment theory behind this risk management technique is that historically the value of different asset classes rarely move in perfect tandem with the value of U.S. stocks, in some cases, the value of other asset classes move in the opposite direction to the value of U.S. stocks.
The varying degrees of independence in the value of different asset classes helps to reduce the risk of loss because when U.S. stocks are suffering large losses, it becomes likely that other asset classes are losing less or possibly even generating positive returns.
In either case, the size of the total portfolio loss is reduced through conventional diversification because the portion of the portfolio not invested in U.S. stocks is likely to be generating either smaller losses or offsetting U.S. stock losses through positive returns. Conventional diversification is the investing equivalent to the old saying, “don’t put all your eggs in one basket”, which sounds good but does it always work for investors?
Why Conventional Diversification Fails When You Need It Most
Conventional diversification is not the risk management panacea that the investment management industry would have you believe.
Unfortunately, during periods the U.S. stock market is suffering its worst losses, conventional diversification does little to protect a portfolio from capturing larger than expected losses. It gets worse, when U.S. stocks are experiencing their largest gains, conventional diversification works against portfolios by limiting the gains captured.
To summarize, conventional diversification tends to fail when you need it most and drags down your gains when you need it least. Almost all investors use conventional diversification as the only risk management technique to help lower their risk of loss. The ubiquity of conventional diversification makes it very important that investors understand why it often fails to protect from large losses while at the same time lowering returns during large U.S. stock market rallies.
Below is a brief explanation of why conventional diversification often fails investors, but to get a full explanation, I recommend listening to our podcast episode that dives much deeper into this very important investing topic.
Conventional diversification fails during extreme market events because the normal relationship in how the values of each asset class move relative to U.S. stocks breaks.
Asset classes that usually do not move strongly in the same direction as U.S. stocks, suddenly begin to move in near lockstep and in the same direction as U.S. stocks. When this occurs, conventional diversification fails to reduce portfolio losses and instead increases losses beyond what an investor would expect.
To make matters worse, when the U.S. stock market is generating abnormally high returns, conventional diversification also fails by reducing the size of portfolio returns. During normal markets asset classes that usually move more strongly in the same direction as U.S. stocks begin to move in a less coordinated fashion and sometime in the opposite direction, therefore dragging down portfolio returns.
If you would like professional assistance in evaluating your investment portfolio and strategy, we happily provide free consultations and analysis. Also, consider gaining more unique investing insights by listening to our popular podcast or viewing our investing video series.
3Summit Investment Management is a fiduciary, fee only investment advisor providing clients with an alternative to outdated, conventional investment portfolios. We design custom, modern portfolios capable of delivering greater wealth accumulation with much lower levels of risk. To learn more about how we can help you improve your long-term investing results call (571) 565-2161, email ([email protected]) or visit 3Summit.com.
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