April 15, 2014 at 8:55 AM
The market is a bit like the weather. We spend a lot of time talking about it, but the truth be told there’s not much we can do about it.
However, much as you can prepare for a wide range of climatic conditions, investors can prepare for various economic scenarios. It’s just a question of being humble about the clarity of your crystal ball and recognizing and compensating for certain behavioral instincts that can be injurious to our economic welfare.
Here are three ways you can put the odds in your favor for whatever the market throws your way.
Don’t Over Diversify
Diversification. It’s the only free lunch in investing. It’s guaranteed to reduce your risk, without necessarily reducing your returns. It’s the only responsible strategy in a world where you don’t have tomorrow’s Wall Street Journal today.
There are diminishing returns from diversification. Two positions cut your risk in half, three positions by another sixth, four positions by another twelfth, etc.
The extreme over diversification comes when you’re working with mutual funds. Most mutual funds have over 100 positions. With one fund, you’ve virtually eliminated the risk of a single stock blow up.
The problem arises when you start adding funds to your portfolio the way you might add individual stocks. You’re not getting more diversification benefits; at best you can expect to mimic the market, because your portfolio is approaching holding everything in the market. There is no focus; one fund may be selling what another is buying. There are too many uncoordinated left hands and right hands.
Holding everything in the market is an index fund strategy. If you’ve turned your portfolio into one large index fund, you’re wasting your time paying high fees to star managers, the actions of which may well be cancelling one another out.
Avoid over diversification, particularly with mutual funds, or throw in the towel and select a low cost index fund.
Eschew Under Diversification
No one admits to being under diversified. Still, it happens time and time again. The most likely causes are attachment for your employer’s stock or stock received from a loved one.
There’s no doubt that the typical investor knows the business where she works best. That breeds confidence. However, it doesn’t justify an overweight position in that security.
We’ve seen over and over how even the C-suite was in the dark about its own business. Think AIG, Lehman, WorldCom, Enron, and Tyco. If senior management is clueless what hope do you have?
Remember, your job’s already at the risk of your employer’s health. Don’t add to the risk by holding stock in the employer, to say nothing of having it comprise too much of your nest egg.
The story is similar with stock received as a gift or inheritance from a family member. Although you don’t have your job at risk with the same company, too often the outsized exposure is rationalized because the family member admonished you to hold onto the stock. Or, you think it’s always been a family holding so it should stay that way. That type of justification doesn’t warrant failing to reduce your exposure and staying diversified.
Everybody wants to buy into a winning story, a manager that’s doing well, a favorable trend. Indeed, in most areas of business you keep adding resources to what’s working and subtracting from what’s not.
Investing is different, because what appears to be working will often be priced that way. In the markets, everything is generally priced according to the prevailing story. You won’t make money by paying top dollar or more for a story that’s already known to other investors.
It’s an unfortunate fact that few investors capture the returns of the average mutual fund. After the fund has turned high, investors stampede in, only to beat a hasty retreat when performance starts easing.
Consider that most investments are cyclical; reversion to the mean is the rule. Stick with quality investments, but buy them when shunned by the public, or simply out of favor. Ease up your buying or exit when the masses embrace them. Try to buy low, sell high.