This is the light fixture in my home office:
As you can see, it has 4 bulbs. On a regular basis one of the bulbs burns out. Eventually, I ask my handyman extraordinaire (aka my husband) to change the burnt bulb. And then the next time I flip the switch I always have the same reaction: “WOW, it is SO much brighter in here.” Every single time! Gaining a light bulb always seems more dramatic and noticeable than losing one.
And then one day I realized that gaining a bulb IS more dramatic than losing one from a mathematical point of view. When I lose a bulb (from 4 to 3) I lose 25% of the light. When I gain a bulb (from 3 to 4) I gain 33%. On the rare occasion that 2 bulbs go out in quick succession, I lose 50% of the light, but then gain 100% when I go from 2 back up to 4. That is REALLY noticeable.
What does this have to do with investing you ask? Excellent question.
When the stock market goes down, you need a correspondingly larger gain just to get back to even. If you have $40,000 in the stock market and the market loses 25% your $40,000 becomes $30,000. Now you need a 33% gain to get back to your original $40,000.
These ups and downs in the markets are termed volatility. Volatility is an inherent part of the investing experience. It is one risk you and I endure in order to reap rewards. Risk and reward are inextricably linked in investing. (Don’t let anyone try to tell you differently). The downside of volatility can be gut wrenching. It’s no fun to watch balances go down. Some people are so fearful of volatility they would rather keep all of their money in cash. But unless you have a seriously large mountain of cash, this will not help you reach your financial goals because inflation will steadily erode the purchasing power of your cash.
While eliminating volatility is not advisable, reducing volatility can help people sleep at night, stay the course, and can result in better investing outcomes, especially over long periods of time. (For details see chapter 2 of “The Investment Answer” by Daniel C. Goldie and Gordon S. Murray, an excellent primer).
How do you reduce volatility in a portfolio? By diversifying across different asset classes. By combining typically less volatile asset classes (such as bonds) with typically more volatile asset classes (such as stocks), you reduce the overall volatility of the portfolio.
For example, in 2008 the Vanguard 500 Index mutual fund, an all-stock fund that aims to mirror the S&P 500 index, lost 36.97%. But a portfolio that was 50% stocks and 50% bonds only lost 15.91% over the same period. Still a loss to be sure, but a much less dramatic one.
It is also important to diversify within asset classes. This means buying stocks or bonds issued by a large number of companies or governments. For example buying a mutual fund/ETF made up of stocks or bonds from hundreds or even thousands of issuers instead of trying to cherry pick a few individual issues. Don’t look for the needle in the haystack, just buy the haystack.
To continue with my office light analogy, I could reduce light loss by diversifying the sources of my light. I could replace two of my incandescent bulbs with LEDs. I could get some candles, a kerosene lamp, and a flashlight. I could leave my shades open to take advantage of solar light.
Investment volatility, like burnt out light bulbs, is part of life. Reducing volatility through broad diversification is one of the biggest tasks an investor faces. What is your asset allocation? Are you well diversified both across and within asset classes? All investors, both do-it-yourselfers and those who work with an advisor, should know the answer to these questions—your financial future could depend on it.