Quiz!
Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)
- Diversify and include some lower risk investments that performed well in the past 10 years.
- Lower your risk by holding some bonds.
- Lower your risk by holding some cash.
- Don’t make any change.
- Increase your allocation to the investment.
5 Rules of Thumb to Avoid Making a Painful Investment Change
Have you ever seen your diversified investments perform poorly for an extended period of 5-10 years, and felt that it would be prudent to diversify to reduce your risks? Have you moved money to an investment that felt much safer based on those years? In most cases, such activity would increase your risk – the opposite of your intended action. In some cases, the results could be painful.
How can a shift to reduce risk end up being painful? Diversified investments tend to be cyclical. The risk of a tough decade following a tough decade is lower than typical, not higher. Furthermore, the risk of a tough decade after an exceptional decade is higher than typical. Here is a case that may be familiar to you: In the late 1990’s US Large Growth stocks seemed like the safest stocks in the world. A switch to these seemingly safe stocks could have led you to losing 30% of your money over the following 10 years (total returns, including dividends, starting 3/1999). If you would have switched away from the seemingly risky Value or Emerging Markets stocks, your pain would have compounded, by missing phenomenal growth.
How can you avoid making a flawed change? Here are a few rules of thumb:
- Compare your investment performance in the past 10 years to the long-term performance (ideally 30+ years). If the past 10 years were below average, the investment is likely to be less risky than usual, not more. Don’t make a change!
- Do the same for the target investment you want to diversify into. If the past 10 years were above average, the investment is likely to be more risky than usual, not less. Don’t make a change!
- Do the same when comparing valuations, as presented by Price/Book. If the change would increase your Price/Book, you would sell low and buy high, something that can hurt you.
- Imagine living through a period with the opposite recent performance – would you still feel that you are reducing your risk with the intended change? If not, the alarm bells should be ringing.
- Say that someone urges you to diversify your portfolio, given the risk of your current portfolio, as presented by recent performance. Check how diversified your current portfolio is. If it includes 100’s or 1,000’s of stocks, split over many sectors in many countries, you are probably already diversified. The phrase: “You should diversify”, is a disguise for the real intent: “You should buy the recent winners, no matter what it does to your diversification.”
How can you use the information above today?
- Just like in the 1990’s, US Large Growth stocks performed far better than their long-term average. They averaged about 13% per year over 10 years, compared to a 10% long-term average. You should realistically expect the returns in the next 10 years to be much lower, not just below 13%, but far below 10%. In addition, the P/B of these stocks is far above average, another warning sign for poor upcoming returns.
- The reverse is true for Emerging Markets stocks. They grew far below their average. For example, the MSCI Emerging Markets Index grew by a mere 4.1% per year in the past 10 years, compared to 10.5% nearly 32-year average. Returns above the 10.5% average in the next 10 years are the likely outcome.
A few words of caution: cycles don’t have a fixed length. Returns that are better or worse than average can continue longer or shorter than expected. In addition, long-term averages can fluctuate. While no result is guaranteed, the information above can help you work with the odds, and not against them.
Quiz Answer:
Which are good ways to reduce your risk after 10 years of poor returns for a diversified investment? (There may be multiple answers.)
- Diversify and include some lower risk investments that performed unusually well in the past 10 years.
- Lower your risk by holding some bonds.
- Lower your risk by holding some cash.
- Don’t make any change.
- Increase your allocation to the investment. [Correct Answer]
Explanations:
- Answers 1-3: Diversified investments tend to be cyclical – selling after 10 tough years, is likely selling low. Buying an investment that performed unusually well at the same time, is likely buying high. This will likely increase your risk.
- Answer 4: While future returns are likely to be above average, and risks below average, no change will keep your risk profile at the same reduced level.
- Answer 5: Buying extra at a very low point may reduce your risk, if valuations (Price/Book) are far below average and the investment is diversified.