You can drive a car with a broken suspension system, but it will be an extremely uncomfortable ride and the vehicle will be much harder to control, particularly in difficult conditions. Throw in the risk of a breakdown or running off the road altogether and there's a real chance you may not reach your destination at all.
In the world of investment, a similarly bumpy and unpredictable ride can await those with concentrated and undiversified portfolios, or those who constantly tinker with their allocation based on a short-term rough patch in the markets.
Of course, everyone feels in control when the surface is straight and smooth, but it's harder to stay on the road during sudden turns and ups and downs in the market.
And keep in mind the fix for your portfolio breaking down is unlikely to be as simple as calling a tow truck.
For that reason, the smart thing to do is to diversify, spreading your portfolio across different securities, sectors, and countries. That also means identifying the right mix of investments (e.g., shares, bonds, real estate) that aligns with your risk tolerance, which helps keep you on track toward your goals.
Using this approach, your returns from year to year may not match the top performing portfolio, but neither are they likely to match the worst. More importantly, this is a ride you are likelier to stick with.
Just as drivers of suspensionless cars change their route to avoid potholes, people with concentrated portfolios may resort to market timing and constant trading as they try to anticipate the top-performing countries, asset classes, and securities.
Here's an example to show how tough this is.
Among developed markets, Denmark was number one in Australian dollar terms in 2015 with a return of nearly 40%. But a big bet on that country the following year would have backfired, as Denmark slid to bottom of the table with a loss of more than 15%.1
New Zealand has had a stellar run, ranked as the world's second best performing developed share market in three of the past six years (2011, 2014 and 2016). But a decade before, it was a laggard - third worst in 2006 and second worst in 2005.
Australia was ranked the world's second worst performing developed market in 2013 and fifth worst in 2015, before rebounding to fourth place in 2016
Source: MSCI developed markets country indices (net dividends). MSCI data copyright MSCI 2017, all rights reserved. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
Predicting which part of a market will do best over a given period is also tough. For example, Australian value shares were the second worst performers out of 10 major asset classes in 2015, yet the following year they were at number one.
Australian small company stocks were second to last in 2012, last in 2013 and again in 2014, but then moved up to fourth position in 2015 and third in 2016.2
If you've ever taken a long road trip, you'll know that conditions can change quickly and unpredictably, which is why you need a vehicle that's ready for the worst roads as well as the best. While diversification can never completely eliminate the impact of bumps along your particular investment road, it does help reduce the potential outsized impact that any individual investment can have on your journey.
With sufficient diversification, the jarring effects of performance extremes level out. That, in turn, helps you stay in your chosen lane and on the road to your investment destination.
Happy investing (and safe motoring!!).
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Important. Diversification does not protect against loss in declining markets. Past performance is no guarantee of future results. Investing involves risk and the possible loss of principal. There is no guarantee strategies will be successful. This article has been prepared and is provided in Australia by DFA Australia Limited (AFS Licence No.238093, ABN 46 065 937 671). The article is provided for informational purposes only. Any opinions expressed in this article reflect the author's judgement at the date of publication and are subject to change. No account has been taken of the objectives, financial situation, or needs of any particular person. Accordingly, to the extent this material constitutes general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation, and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.