Today’s markets offer a wide variety and number of investments. This presents an enormous challenge, one that entices many investors to scour the market landscape to unearth individual companies that they believe will outperform. History has shown that few actively managed portfolios are able to outperform the market as a whole.
Rather than crafting a basket of individual companies and relying on market timing to get in and out at the right time, research shows that you are better off investing broadly across many markets, adhering to an asset mix that suits your circumstances: a blend of stocks, bonds and other asset types – and geographic location of these – that works best for your age, personal circumstances and temperament.
Diversification reduces risk without hindering performance. This reduces the impact of individual companies and enables investors to scientifically employ the risk factors that offer higher expected returns. Keeping one’s eggs in more than one basket is the age-old means of reducing risk. Investing across various asset classes – stocks, bonds, real estate, cash, and subsets of each – allows you to profit (and avoid or minimize losses) at any stage of the market cycle.
Investment professionals trade trillions of dollars in securities each day. This means markets are generally efficient and prices incorporate all publicly available information. Indexing (or buying all the companies in any given market) reduces the individual company risk through diversification, which allows you to focus on managing beta (overall market risk) as opposed to chasing elusive alpha (trying to beat the benchmark). Thus it makes sense to participate in markets by investing in indexes rather than individual stocks. The result is a low-cost and hyper-diversified portfolio.
Many investors believe they are achieving diversification by spreading their money around several portfolio managers. However, this only protects you from active manager risk, not from excessive concentration. If, for example, you own four Canadian equity funds run by different managers, it’s likely that these funds have a large measure of overlap in the securities they hold.
Asset allocation is the key to portfolio performance, not active management. A portfolio should reflect your risk tolerance across equities and fixed-income assets, and should be adjusted as values within each asset class fluctuate – and as your financial situation changes over time.