Go back to the basics to successfully diversify your portfolio

You could probably outperform 90% of investors today by following two platitudes we’ve all known since childhood:

  1. Don’t put all your eggs in one basket
  2. Buy low and sell high

This seems simple enough, but with Dalbar’s research showing that investors destroy 60% of their portfolio’s performance with emotional decisions, this advice is harder to follow than we might believe.

But why?

Diversifying

Diversifying

Don’t put all of your eggs in one basket

The basket is an investment and the eggs are your capital. The lesson is simple: put your capital into multiple investment baskets.

Most people interpret this as: diversify your return sources to increase your chances of profit. However, smart investors know it’s much more fruitful to diversify risk sources, which reduces your chances of loss.

It’s as important to split up your eggs into multiple baskets as it is for those baskets to have different functions. Since downsides are inevitable, having a variety of baskets to hold your eggs sets you up for the highest likelihood of success.

A bully might come along and step on one of your wicker baskets. But if your other one is made of reinforced steel, he won’t make a dent in it. If you’re properly diversified, one force usually won’t affect all styles of investing the same way. So, it’s not too daunting to recover from your loss. You put more eggs in your depleted basket as income comes in, and soon you’re back to where you started. In this manner, diversification can be a long-term profit center—your overall portfolio recovers more quickly because your drawdown was isolated to one area.

However, if all your eggs are in wicker baskets – taking the same types of risk – a bully on a full-fledged stomping rampage can take down a lot of your egg stockpile…and fast. The investors who focus on diversifying performance rather than risk can easily fall prey to this rampage and will experience much more pain during downsides, including larger maximum drawdowns.

But putting eggs in different baskets is only half the solution.

Buy low and sell high

A simple concept in theory, this is much harder to follow in practice. In most other parts of life, you easily follow this advice. You haggle on the price of a new luxury automobile. You ruthlessly negotiate the price of that new home in the best neighborhood.

But for some reason with investments, investors tend to crowd in at all-time highs, then consider themselves the unluckiest of investors when the market hits an inevitable down cycle.

The two main emotions driving this are greed and fear.

Greed causes investors to chase performance: buying what was up the most recently (buying high) and selling things that are not working and declining (selling low).

Fear of losing money further aggravates this, because when your entire portfolio is in decline the natural reaction is to get scared and sell everything (selling low). Investors often intend to buy back in when things calm down (most likely when prices are back up – again, buying high).

Rebalancing each year is one way to skirt this behavior.

Checking in on your portfolio too often is like tracking the ups and downs of the housing market day to day. Investors will be unnecessarily worried about short-term performance over long-term value. But, for most investors, harvesting investments once each year to balance the risk in their portfolio helps reduce that risk. When greed and fear inevitably rear their ugly heads, investors who rebalance annually are much less likely to cause long term damage to their portfolio.

Diversifying your baskets and rebalancing your risk are intrinsic investing behaviors. But the more complex the investment, the easier these basic principles are to forget. That’s why going back to the basics is most important for investments that reside in an investor’s alternatives sleeve.