The Importance of Diversification in Investment
Investors often find it challenging to convince themselves to diversify between stocks and bonds when stock markets are rising and bond yields are falling. The performance of assets in their account summaries is what catches their attention. In the U.S. stock markets, as of mid-May, the S&P 500 Index has seen a 12% increase since the beginning of the year. The Dow Jones Industrial Average has also surpassed the 40,000 point mark. The idea that the high performance of the S&P 500 is being ‘envied’ by many investors has become widespread.
According to a report by MarketWatch, similar conditions to the ‘S&P 500 envy’ concept observed in 2018 can also be seen in recent days. The world’s largest investment firm, BlackRock, prepared a presentation for financial advisors on this topic. It is known that long-term portfolios tend to perform well over time. However, BlackRock highlights in its updated research for 2023 that during periods when the S&P 500 is declining and sample portfolios are falling less, such as 2000-2002, 2008, 2020, and 2022, hypothetical clients are ‘saddened by losing money.’ Similarly, during periods when the S&P 500 has significantly increased and sample portfolios have risen less, like in 2009-2019 and 2023, hypothetical investors are ‘unhappy for not earning enough.’
Dealing with Short-Term Rise Bias
Nicholas Olesen, a Certified Financial Planner at the investment management firm Kathmere, refers to a similar analysis published in 2018 that remains relevant today. Olesen argues that having a mix of different investment types is the best choice in the long run, backed by data showing the fluctuation of various economic components.
Behavioral finance refers to this situation as ‘innovation bias,’ where investors tend to believe that the latest trend will always continue. This bias is one of the most significant obstacles to diversified portfolios. Despite potential financial crises, financial advisors advocate for a balanced approach and long-term thinking in investments.
The Benefits of Diversification
Olesen emphasizes that diversification is not designed to provide you with the portfolio that will perform best right now but is tailored to deliver the desired results in the long term. He states, “Diversification is not about giving you the best-performing portfolio right now; it is designed to give you the results you want in the long term.”
Dealing with diversification discussions has reportedly been much smoother with the firm’s long-standing clients compared to new investors. The investment expert advises, “We are all human and fall prey to the fear of missing out (FOMO). Do not let your emotions guide your financial decisions. Take a step back and think logically. Most people later fully understand why we diversified our investments.”
