Diversify Investments for an Unknown Future

I WILL NOT try to predict the future or listen to those who claim they can. Whatever happens next is anyone’s guess. I can take comfort in knowing that I am properly diversified.

Living up to our “wet-coast” reputation, it rains nearly every second day on Vancouver Island. Although, rainfall and sunshine generally don’t alternate, forecasting the weather is extremely difficult – especially over longer periods of time. I have no idea if it is going to rain on this day next year, nor do I know if we will be in a recession. Did you know that through the 1990’s, economists were only able to predict two of 60 recessions one year in advance?

Leading economic indicators, such as unemployment claims, trade volumes and manufacturing activity suggest that we are not in a recession today, nor will we be tomorrow. However, the odds are stacked against those attempting to forecast where the economy will be in twelve months from now, especially considering the track record held by a panel of “experts.”

Legendary, former mutual fund manager, Peter Lynch, famously quipped, “far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” Over the short-run, cash can rest on the sidelines, but be sure that it doesn’t sit out for the entire game. The opportunity cost of not being invested might turn out to be higher than the short-term paper loss of having held your investments through a correction.

Franklin Templeton shows in one chart how unpredictable returns are for various asset classes on a year-by-year basis.

What’s an investor to do in such an unpredictable economic environment?

Most investors have heard the axiom not to ‘put all of their eggs in one basket.’ Who better than Investopedia to define Diversification:

Di•ver•si•fi•ca•tion (noun): A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.

I couldn’t agree more. However, being properly diversified does not mean that you own the entire index either. Exchange Traded Funds (ETF’s) continue to attract investors, largely due to how cheap the management fees are. Most investors don’t stop to think about why it is that the fees are so low.

An ETF doesn’t hire a team of research analysts to flip through financial statements or a portfolio manager to allocate your money to wealth creating industries. Instead, an ETF indiscriminately owns an entire basket of stocks in a given industry or country – that’s right, all the good ones and all the bad ones too. They are the financial equivalent of setting your car on cruise control and climbing into the backseat for a nap. I hope that the road that you’re travelling down is extremely straight and you’re the only car in sight.

Rest assured, your investment portfolio does not own the entire index.

The fund managers that we’ve hired to look after your hard-earned money are working just as hard for you, acquiring well run businesses in your investment portfolio.

With respect to one’s ability to forecast, focus on the known knowns—things that we know to be true, like the weather at this very moment. Spend less time worrying about the known unknowns – things that we are aware of but have no control over, like if it will be a white Christmas. Finally, spend even less time speculating about the unknown unknown’s – things that we have no control over and cannot predict. Instead, trust that your portfolio is properly diversified and can weather the uncertainty.