For years, we’ve been tracking the returns of various asset classes. It would sure be nice if we knew which one would be the best investment for 2017 (and every year for that matter)! Unfortunately, that’s not the case.
Investment returns are illusive at best in the short run. Illusive is an understatement actually, since it’s impossible to predict the next best investment for 2017 or any period of time.
Since investment returns are random year by year, we always diversify. As the old adage goes, we never put all of our eggs in one basket. In fact, we don’t even put most of our eggs in a single basket. For all of it’s benefits however, diversification is a funny thing!
The Problem With Diversification
The problem with diversifying an investment portfolio is it makes you an automatic loser. That’s right, you’re guaranteed to be a loser.
A loser – by default – is something which underperforms something else. The winner outperforms everything else. Next to the winner however, everything else is a loser – albeit to varying degrees (2nd place, the bronze medal, a white ribbon, etc.).
Diversification of your investment portfolio requires investing in different things. As such, one investment will always win and everything else will lose to some extent. Therefore, diversification means you’ll always be a loser somehow, because you didn’t invest everything in the winner.
The Benefits Of Diversification
There’s a silver lining to this cloud however. While diversifying your investment portfolio means you’ll never be a 100% winner, you’re also guaranteed never to be a 100% loser.
Your great performing investments will balance out with your worst performing investments. You’ll never make a killing, but you’ll never be killed.
This reminds me of the very first investing quote I learned (over 20 years ago) when I started in the financial field:
Bulls make money
bears make money
pigs get slaughtered
Granted, I started my career in 1995 as a (hold your nose) “stockbroker” with Morgan Stanley (I’m a fee only fiduciary advisor now). The big brokerage and insurance firms sell investment “stuff”. As such, their training and techniques were geared to pitch products. Those products – and the industry sales tactics – generally appeal to pigs!
What the quote means is:
- A bull (meaning you’re hoping the investment rises in value) can make money by owning the investment outright
- A bear (meaning you’re hoping the investment falls in value) can make money through derivatives or selling short when an investment sinks
- A pig (meaning you’re using random tactics to time/trade/buy/sell investments to make the most money in the shortest time) is destined to lose!
Diversification is a long term process of owning several types of investments. Diversification is a bullish investment strategy. While I’m sure bears can diversify as well, it’s hard for me to imagine buying lots of investments you want to sink in value concurrently as a viable strategy.
Since diversification is a long term bullish strategy, you’ll never be a pig! Ergo, you’ll never be slaughtered!
Diversification By Asset Class
In the world of finance, there are many types of tools and vehicles you can invest in. Each have their own nuances and ability to gain or lose value over time.
Smart investors invest in asset classes. Asset class investing means you dissect chunks of investments with highly similar characteristics. Those are your asset classes, and you invest portions of your portfolio in them.
The main asset classes are stocks, bonds, and cash. Many financial advisors would add alternative asset classes, such as commodities, to this very short list.
Within those main asset classes are several subsets. Asset classes such as small cap value stocks and emerging market stocks are part of a diversified investment portfolio.
Even highly “non-traditional” investments such as coins, cars, pool cues, firearms, and art can be considered for diversification purposes. And I didn’t just make those up, we have clients who include those types of investments in their overall asset allocation plan.
Here’s a cheat sheet of some of the major asset classes you can invest in:
Each asset class has it’s own risk/volatility and long term return characteristics. Some have higher returns and commensurate risk. Others are quite conservative in nature, with little fluctuation and little propensity for higher returns.
Investment Returns Are Random
No one knows which investment will be the best performer over any future time period. If I knew the best investment for 2017 prior to January 1st, 2018, I’d make a mint!
Unfortunately, investment returns are quite random in nature. Take for example the following chart of investment returns by asset class (click to enlarge):
Can you spot any trend or pattern? If you do see one, would you rely on it?
Of course you wouldn’t. The odds of you being wrong are immense, and your chance of being right is miniscule. Rather, you’d diversify your investments.
Diversification guarantees you’ll own the best investment for 2017 (or any year for that matter). It also guarantees you’ll own the worst investment!
In the chart above there are some nuances – dare I say trends – which stand out to me. Real estate tends to do really good, or really bad!
Commodities are quite similar. They perform really well or really crummy. Same with international and emerging market stocks.
Those things are to be expected. REIT’s, commodities, and international companies have historically shown a high degree of volatility. There are many reasons for this, all of them well beyond the scope of this post.
It appears other asset classes are all over the board. They tend to be more moderate in risk and returns, but they’re all over the board in no consistent pattern.
The Moral Of The Story
I absolutely LOVE this chart! That’s why we keep it updated each year. It’s an excellent depiction of just how random investment returns are.
You can’t predict the future, no one can. You don’t know more than anyone else does – that’s simply impossible in this day and age of lightening fast technology and information.
Investment returns are quite random. Diversification is the only prudent approach in an unpredictable financial world!