Last week was a reminder of the value of diversification. A bank that focused on a niche portion of the economy succumbed to “unexpected” events. The fallout took down the investors, but not the depositors. This is a serious issue for those directly impacted and a valuable lesson for the rest.
Enough ink has been invested in explaining what happened with the bank and how it could have been predicted. What you need to retain as a learning experience from other people’s pain is that diversification matters.
Diversification regarding investing implies owning different things, but there is more to it than that. You need to own different companies, different sectors of the economy, and different asset classes. Diversification implies you won’t receive the best nor the worst return.
The impact to the individual bank falls under company-specific risk. Some investors understand and even prefer owning investments noted for amazing results. The rate of change could be glorious or disastrous and should only be undertaken when the potential downside is understood. Keep in mind that “amazing” in this instance is defined as abnormal, albeit good or bad.
Individual stocks increase the likelihood of larger potential swings in day-to-day volatility. Stock-specific risks include management, financial miscues, mergers and other specific implications. This risk can be mitigated by owning a group of similar companies known as a sector.
Sector ownership also offers risk. The bank failure last week created havoc for the entire banking sector. Although they all certainly didn’t go out of business, the other bank stocks endured extreme levels of downside volatility.
Owning varying asset classes – stocks, bonds, cash, and companies of different size – minimized your portfolio impact. Simply owning more “eggs” in your proverbial investment basket did not shelter you from having a frustrating result.
Businesses are rewarded for focusing their efforts, and our economic system needs that focus. The biotech environment, for example, creates more failures than success, but the medicines they create are important for humanity. That doesn’t mean you should invest your retirement nest-egg in the same way.
Your greatest protection from wild market swings is owning a diversified portfolio. That also means accepting that you won’t also receive heroic total returns. Diversification does have its limitations and drawbacks.
Unfortunately, many investors believe that owning an index or a mutual fund eliminates exposure to large market swings. Indeed, owning an index or diversified mutual fund limits singular exposure mentioned above, but it will not necessarily prevent market declines from major events.
The increased usage of social media as a news source has proliferated “fake news” and bad information. Additionally, the access to mobile banking and immediate reactions to the news can accelerate market conditions – positively or negatively.
Your best defense is knowing what you own, know why you own it, and be fully aware of how your portfolio functions together to provide you the desired result. Sound investing isn’t easy, even if buying stocks is at the click of the proverbial button.
