Investing in a diversified portfolio is a cornerstone of our investment philosophy at Master’s. Extensive academic literature suggests that diversification not only reduces risk but also smooths returns and, over time, tends to outperform individual stock, sectors, or indices.
However, diversification comes with its challenges. One significant drawback is that in a diversified portfolio, there will always be investments that do not perform as well as others. This might seem counterintuitive. Why hold onto investments that lag behind the rest of the portfolio? The simple answer lies in the unpredictability of market performance. Instead of chasing the highest performers, like a dog chasing its tail, diversification spreads investments across assets, acknowledging that some will underperform at any given time.
This dynamic played out notably in the markets during 2022 and 2023 and is evident again in recent weeks. Consider two investments and their performances over the past two calendar years, starting with a $100,000 investment at the beginning of 2022:
- Investment A: -32.7% in 2022, 53.81% in 2023, ending value of $103,514
- Investment B: -5.43% in 2022, 7.97% in 2023, ending value of $102,107
In hindsight, the optimal strategy would have been to hold Investment B in 2022 and then switch to Investment A in 2023. However, this is like a fool’s errand. You might get lucky a time or two, but such recurring foresight is virtually impossible. While Investment A slightly outperformed Investment B overall, the journey was significantly more turbulent.
Now, consider a diversified portfolio. Holding 50% of Investment A and 50% of Investment B would have resulted in an ending value of $105,929, surpassing either investment alone. The trade-off, of course, is that in any given year, one component of the portfolio may disappoint. Yet, diversification offers the benefits of high potential returns from volatile assets like A, balanced by the stability of assets like B, which mitigate risk during market turbulence.
So, embrace the inevitability of having underperforming investments in your portfolio; they often rebound in the future!
For those interested: Investment A represents the NASDAQ Composite Index, and Investment B represents the Large Cap Value Index.
