This week we are going to round out our discussion on good things to do during a bear market with a chat about diversification.
Let's begin with some basic thoughts on diversification and then we will talk about how diversification helps in bear markets specifically.
I’m sure you’ve all heard the saying, “don’t put all your eggs in one basket!” In essence, diversification is the act of putting your eggs in different baskets. That way, if you drop a basket you'll only break the eggs in that one basket, not all the others with the rest of your eggs. Pretty smart for a simple concept right!
Equity Diversification is the act of investing in multiple areas that would likely act differently during a market event. By buying stocks in these different categories, you reduce the risk that if the value drops in one area, the value will rise in another. For example, let's say you buy stock in airlines. That might seem like a great idea with a beautiful summer in full swing, right? Well, imagine a pandemic tears through the globe, and international travel ceases for two weeks (which is code for one year); what then? (Not that something like that would ever happen, ahem!) Well, if you allocated strategically between stocks in airlines and stocks in automotive transportation, such as RV’s any losses in the airline stock may be buffered by your RV holdings.
One thing to be aware of here is the risk of being related which is caused by having your stocks relate too much to each other to reap any real benefits of diversification. The example I gave of airline stock vs. RV stock is not incorrect. By buying stocks in the different modes of transportation, you can help counterbalance the loss of one transportation method becoming unavailable by reaping the benefits of another transportation method taking its place. We will never not need to get somewhere, so having stocks in different ways of doing that is likely a good idea and a good example of diversifying your portfolio. But these benefits only become more significant, and the safety net only becomes stronger when your stock collection becomes even broader. The more diverse and different your investments are from one another, the more likely you are to avoid loss in many of the areas you have invested in. The key is that the stocks should be so different from each other; a move in the market might impact some categories but leave others completely untouched.
Investing in airlines and RV’s is great, but what about also investing in something totally outside transportation - like, ice cream? Let’s say you buy a stock in an ice cream company, and when the world shuts down, and quarantine begins, the loss you might feel from families unable to transport anywhere at any time will be confined to those two areas of your portfolio. The ice cream stock is safe, stable, and untouched, especially since everyone is home with nothing to do but eat ice cream.
So, buying stocks in diversified companies and categories is a little bit like an insurance policy. But I said the broader the better. Airlines and ice cream are a pretty odd combo, so they’d look great together in your portfolio, sure. But the differences can go even further. Diversifying your assets in terms of stocks vs. bonds is another excellent way to split your eggs, specifically because stock eggs and bond eggs typically act inversely during market events. When the market swings, bonds will rise while stocks typically fall and vice versa, depending on the scenario.
Many people make the mistake of moving their money in with them, confining it to one location (their location), and refusing to send it out to different parts of the world. By owning stocks in your area only, you are susceptible to loss when an event occurs that impacts your location. When you choose to keep your money in stocks tied to different areas, you can be sure that even when the market moves down in the place you live, the market may be stable elsewhere. For example, if the market falls in the United States, stocks you own overseas might be smiling and waving from across the water.
Your investments are safer when they are spread out across multiple companies, categories, and asset types. The more different your money is, the more durable it will be. Diversifying helps it become less susceptible to market shifts and more likely to balance or counteract financial falls. All together, diversification is highly beneficial when it comes to risk management and is often encouraged by financial advisors and bunnies alike.
Diversification in Bear Markets
Two important things you should know about diversification in bear markets are:
- Diversifying into less risky stocks can minimize bear-market losses and offer long-term benefits.
- Going into cash during a bear market is likely to depress returns following the recovery for many investors.
Bear markets tend to savage growth stocks more so than value ones. By a happy coincidence, lower-risk stocks have generated long-term returns similar to those of riskier ones, despite the lower risk.1 For portfolios tilted towards speculative stocks, that means some diversification into value, even if it is overdue and takes place during a bear market, can pay dividends figuratively as well as literally long after the bear market is history.
Even cash has a role in a diversified portfolio. Although it doesn't earn much yield, cash represents a reserve of buying power that can be quickly marshaled as the bear market presents opportunities. But if you place a significant proportion of your retirement account into cash during a bear market, you'll face the unenviable task of having to figure out if, when, or where to redeploy it, or else face diminished long-term returns.
Market timing, as we said in week one, is like trying to pick the fastest lane in heavy traffic - it doesn't work and you end up standing still watching other cars pass you. On top of that, attempting to time the market will most likely leave you poorer. For example, Fidelity 401(k) plan participants who changed their equity allocation to zero between October 2008 and March 2009 and then invested in equities again after the downturn gained 25% through June 2011, versus 50% for those who left the allocation alone.2 Not too shabby!
Until next time…
One last thought, I believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share.
1 AQR. "Defensive Equity," Page 6.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. An investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.