A quick check of the financial news reveals that the stock market has moved into its ninth straight year of rising values. So, what does this mean? It means that diversification is more important than ever.
The Cyclical Nature of Financial Markets
Some analysts and financial pundits issue dire predictions of pending doom, likening the current market to the days immediately before historic crashes, such as the Great Depression. Others say today’s low interest-rate environment, coupled with several other factors, means the market is valued fairly. Some honest types readily admit that they believe the stock market is overvalued, but they have also believed that for the past three years.
The truth is, if market peaks could be accurately predicted, we would never be caught by bubbles, recessions, or plain old market crashes. All markets are cyclical and unpredictable; when one market cycle finishes, the next begins.
Unfortunately, during prolonged bull markets, many investors tend to forget about the cyclical nature of the financial markets and they chase returns. As a result, they take more risks and are soon outside their risk-tolerance comfort zone. When the market turns, they panic and withdraw, often selling at a low. Then, when the dust settles, they want to buy back in. After suffering from analysis paralysis, they typically re-enter after the market has recovered, creating a highly unprofitable sell-low/buy-high cycle for themselves.
Diversification is Key to Protecting Yourself
The key is to diversify your investment portfolio in a manner that fits your personal investment style, your risk-tolerance level, your long-term goals – and then stick with it.
A diversified investment strategy is not a cure-all; you will still experience losses if the market drops significantly. Why? Because there are two main types of risk, often referred to as systematic and unsystematic risk. Systematic risk, or market risk, is caused by events that are not specific to a particular company, industry or asset class. You cannot create a diversified portfolio that is immune to this risk.
On the other hand, a diversified portfolio will give you a level of protection from unsystematic risk, which is associated with specific stocks, industries or asset classes. For example, a well-diversified portfolio might include a strategic mix of stocks across different industries, as well as across asset classes, such as bonds and/or commodities. The goal is to invest in assets that react differently during specific market events. For example, if the stock market crashes, bonds often increase in value.
Remember, however, that investment risk can never be completely offset. Sometimes, investors with well-diversified portfolios mistakenly believe that they will be immune to market losses, so when they experience loss, it can cause unnecessary panic.
The Importance of Risk Tolerance
If you fully assess your risk-tolerance and invest accordingly, you will be less prone to panic during volatile markets. Risk tolerance is very individualized, but you can calculate it by being honest with yourself about how much risk you are willing to withstand. What amount of loss makes your stomach churn? Stay well away from that amount—even if attractive returns tempt you to ignore your personal comfort levels.
No one can predict the future, and this is just as applicable to financial markets as to life itself. Has the stock market reached its peak? Are we due for an historic crash? Regardless of what comes next, a well-diversified investment portfolio, an appropriate risk- level, and a solid long-term strategy will help mitigate emotion and keep market events in the proper context.
Craig Birk, CFP®
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