No one likes to see their portfolio decline in value.
It’s only natural. After all, who wouldn’t rather watch their investments bring in nothing but an uninterrupted series of dramatic gains? The problem with this all-too natural desire, is that it can sometimes lead us to make some very bad decisions.
Psychologists will tell you that, for most people, the aversion to loss is far greater than the attraction to any potential gain. That’s why, when our portfolios decline for more than a few days in a row, we begin to feel like all the gains we worked so hard to achieve are about to slip through our fingers. So we ask ourselves, why are we stuck with these crappy investments, while all around us other investments are going up in value every day?
It’s no wonder that investors are constantly searching for some way to be sure they pick the “right” investment – namely, one that gives us all the upside of investing in equities, but which never goes down in value. A sort of risk-free, high-paying, guaranteed investment certificate.
This quest to distinguish the winners from the losers has spawned a gigantic (and hugely profitable) industry, whose only goal is to tell us which are the “best” stocks, mutual funds, money managers and analysts to entrust with our cash. “Best,” of course, meaning those that only ever move in one direction: up.
But what all those highly-paid stock pickers don’t tell you is that, when you sign on to join them in their quest, you aren’t really starting down the road to investment nirvana. What you’re actually signing on for, is the right to subject yourself to an enormous amount of unsubstantiated risk, which could seriously compromise your long-term investment results.
Why? Because as strange as it may sound, the vast majority of investors who focus their efforts on picking the “best stocks” and avoiding market fluctuations, actually end up putting themselves in far greater peril than if they’d simply left well enough alone.
The reason for this seemingly bizarre result is simple: there are two types of risk in investing, and they’re present whether you’re putting your money into stocks, bonds, gold, real estate or just about anything else you can imagine. The only real choice investors have, is whether they want to take on one of these risks – or both of them.
The first is systematic risk. This is the risk that any given asset class, such as stocks, could go up or down over time, due to the macroeconomic swings and conditions that affect the market as a whole. If you have a broadly diversified portfolio of stocks, odds are, your portfolio will go up or down when the market goes up or down. Individual stocks within your portfolio may swim against the market tides. But if your portfolio is sufficiently broad, over time, it will essentially do more or less whatever the overall market does.
The second risk is unsystematic risk. These are the risks that are unique to a particular company, stock or piece of property. Because these investments are unique, they have a tendency to go up or down all on their own, no matter what the larger markets may be doing.
Sometimes this is good. For example, if you own a piece of land and you happen to discover that it’s sitting on a massive untapped oil reserve, the value of your property would increase significantly. On the other hand, if that same patch of land turned out to be contaminated with toxic waste, it’s going to go down in value rather drastically, regardless of what the market for real estate happens to be doing.
The same is true for stocks. If you own a stock in the company that discovers a cure for the common cold, you’re about to become a very wealthy investor. But if you own shares in a company whose CEO becomes embroiled in an accounting scandal, those shares will drop in value even if the rest of the market is climbing.
The good news about unsystematic risk is that it can be diversified away. If you buy one share of one company, you’re opening yourself up to a whole world of potential risk. But if you buy 1,000 stocks across a whole range of industries and geographic regions, then you make yourself immune to the changing fortunes of any particular company.
You’ll still see drops and increases in value as the market goes up and down. But the fate of any one firm, or even country, will no longer be a significant event in your investment life.
The bad news about unsystematic risk is that people still insist on taking it. They voluntarily choose to take on both the unavoidable systematic risk of the market, as well as a healthy dollop of unsystematic risk, by concentrating all or most of their portfolio into a few single stocks or sectors.
I have no doubt that they’re doing this with all the best of intentions. They just want to protect themselves from the gyrations of the market, by making sure that their money is always in the right place, at the right time. We even have lots of names to help investors find these perfect stocks. We call them “defensive,” or “highly recommended,” or we tell them to do whatever else is currently perceived to be beating the rest of the market.
This would be a great strategy, if only there was ample evidence that any investor – even the most overpaid experts – can successfully and consistently predict which stock or sector today, is guaranteed to go up tomorrow.
Unfortunately, no such evidence exists. In reality, a whopping 90% of the experts – all those people you’re paying to tell you which stocks to invest in – fail to beat the market over the long haul. And the 10% who do outperform the market? Evidence suggests that they change pretty much every year, so this quarter’s superstar is just as likely to be next month’s deadweight.
All of this would still be okay, if the consequences of trying to pick the single “best” investment resulted in only a minor underperformance relative to the market. But far too many people who put all their eggs into a “sure thing” wake up to find those eggs permanently scrambled, when that sure thing falls to pieces over a sector downturn, the collapse of a foreign bank, or any other specific risk that no one saw coming.
Over the long haul, a broadly diversified portfolio of stocks, bonds and other securities has been proven to provide a superior rate of return over market timing or stock picking strategies, if it is held onto throughout the ups and downs of the market. Broad diversification eliminates unsystematic risk, and the chance for disaster that comes with it.
Why make it any more complicated – or riskier – than it has to be?
Alan MacDonald an Investment Advisor with Richardson GMP Limited, helps investors with over $500,000 of assets make smart decisions about money. Alan is the co-author of "The Copperjar System, Your Blueprint for Financial Fitness" available on Amazon.
For more information please visit www.alanmacdonald.ca or email Alan at Alan.Macdonald@RichardsonGMP.com <!-- /* Font Definitions */ @font-face {font-family:Arial; panose-1:2 11 6 4 2 2 2 2 2 4; mso-font-charset:0; mso-generic-font-family:auto; mso-font-pitch:variable; mso-font-signature:3 0 0 0 1 0;} /* Style Definitions */ p.MsoNormal, li.MsoNormal, div.MsoNormal {mso-style-parent:""; margin:0cm; margin-bottom:.0001pt; mso-pagination:widow-orphan; font-size:12.0pt; font-family:"Times New Roman"; mso-fareast-font-family:"Times New Roman"; mso-bidi-font-family:"Times New Roman"; mso-ansi-language:EN-CA; mso-fareast-language:EN-CA;} em {mso-bidi-font-style:italic;} @page Section1 {size:612.0pt 792.0pt; margin:72.0pt 90.0pt 72.0pt 90.0pt; mso-header-margin:36.0pt; mso-footer-margin:36.0pt; mso-paper-source:0;} div.Section1 {page:Section1
All material by Alan MacDonald, Investment Advisor at Richardson GMP Limited. The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.
Richardson GMP Limited, Member Canadian Investor Protection Fund. Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.
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