At the most fundamental level, investment decisions are determined by two factors: risk and return. While investors may have different goals for portfolio returns and varying appetites for risk, the objective is consistent; maximize returns relative to risk. This is best accomplished through diversification, but constructing a portfolio with a variety of assets does not mean this has necessarily been achieved. Correlation is the key. Correlation, in the finance and investment industries, is a statistic that measures the degree to which two securities move in relation to each other. A composition of assets with low or negative correlation is quintessential for effective diversification. The U.S. stock market is comprised of multiple economic sectors, and these sectors may generally move in the same direction as the market over time, but they do not move in unison with one another.
Retail, telecommunication and energy have failed to keep up with bullish market gains in 2017, which was charged by technology and health care sectors. Expectations for a specific company, sector, or industry can be derived from economic indicators, but indicators can be misleading and trends can expire. Investing heavily in areas of large expected gains can produce large profits, but hedging through diversification in a variety of companies and sectors is prudent and necessary.
Diversification can take many forms
Diversifying equity investments in international markets is another useful strategy to minimize risk. International growth is often a factor of the region and the size of an economy. Diversifying by regions and by developed vs. developing markets can help achieve gains in a variety of market environments.
In addition, an asset allocation mixed with fixed income and equities is a very effective way to minimize portfolio risk. Typically bull markets move in line with increasing interest rates, and as interest rates increase the value of bonds decrease. During any time period returns can be higher for either fixed income or equity investments, but because of the negative correlation between the investment types, a combination of both assets will significantly minimize volatility in a portfolio.
One or two sectors can drive the gains in any given index, especially if the gains are significant enough. Exposure to those sectors will boost the performance of your portfolio, but because of how indices are weighted, a well-diversified portfolio won’t always keep pace with the markets in the short term.
Focus on the long term
Focusing on month-by-month numbers can be risky. An investment strategy should align with long-term goals, not current market trends, and investment goals should be risk-aware. If you’re young and starting your portfolio, by all means, overweight your investments in equities and focus on aggressive growth. You have a lot of time to make up for any negative outcomes from high volatility. If you have an expectation to use your hard-earned savings in the near to intermediate future, your focus should be on risk-adjusted returns and the steadiness of just income.
Give us a call to discuss your risk tolerance and investment goals.