In all areas of life, there are principles to be learned and applied. Finance is no exception. Many bedrock fundamentals found in the Bible have proven their worth over the past two thousand years or more. One is diversification. Spelled out in Ecclesiastes 11, verse 2, Solomon counsels, Divide your portion to seven, or even eight, for you do not know what misfortune may occur on the earth. Another is changes in circumstances.
Unfortunately, our human nature provides us a strong bias toward giving greatest weight to the most recent circumstances. Although this tendency includes bad times as well as good, recent financial results have been quite positive. In the recent past, diversification in your portfolio has likely not been helpful.
The past decade (2010-2019) was pretty unusual. Because most commonly used stock indexes give the most weight to its largest tech companies such as Facebook, Apple, Amazon, Google, and Netflix, indexes like the S&P 500 and the NASDAQ had an incredible performance. But the large capitalized companies segment is just one of several major investing categories.
According to data of Novel Investor, in the past decade, the S&P 500 had one losing year in total returns, 2018, at -4.38 percent. On the other hand, international stock indexes had at least four losing years. Even the much less volatile segment of investment grade bonds had two loss periods in the decade. What to make of this? Is there a new paradigm that makes diversification irrelevant or unwise? Not in my opinion.
Changes in circumstances, or reversion to the mean, is another market principle. While unusual periods do continue for a while, sooner or later, the more normal averages or trends will return. Thus, a decade of unusually great S&P 500 results is not likely to be repeated. However, more DIY investors have decided that putting all their money on this one stock group will be both effective and safe. Even though current economic conditions continue to be very favorable, the most important question is whether you will be ready for the inevitable major downtrend when it begins.
However, it is a terrible idea to be arbitrary in your expectations. Many are making a negative bet now, selling otherwise reliable stocks and stock funds. According to the Investment Company Institute, in the last two weeks of January, about $12B left equity funds while over $23B flowed into taxable and municipal bond funds. The incredible demand for safety and income from bonds has caused them to be extremely expensive by historical comparisons. A bursting of this bubble is likely.
Perhaps 90 percent of investment companies and advisors will never sell as market prices drop. But losing as little as possible in the inevitable bear markets is a key to long term success. If you are preparing to retire, this principle is particularly important for you. Beginning to draw on your investments in a poor market cycle can be deadly to your future financial health. In my opinion, auto-pilot is not a safe means for managing resources.