Investment Shock Absorbers: The Importance of Diversification
Diversification is Still a Free Lunch
We human beings tend to be forgetful. That's why your team at KPP is grateful for simple reminders of time-tested investment wisdom.
Perhaps the simplest and most important investment adage is "don't put all your eggs in one basket."
Based on his recent article, "Investment Shock Absorbers", Jim Parker of Dimensional Fund Advisors would likely agree with this sentiment. In it, he uses the analogy of a car's shock absorbers to point out the importance of diversification, reminding readers that diversifying across securities, sectors, and countries will help investors smooth their ride in the markets.
“Of course, everyone feels in control when the surface is straight and smooth, but it’s harder to stay on the road during sudden turns and ups and downs in the market. And keep in mind the fix for your portfolio breaking down is unlikely to be as simple as calling a tow truck.
For that reason, the smart thing to do is to diversify, spreading your portfolio across different securities, sectors, and countries. That also means identifying the right mix of investments (e.g., stocks, bonds, real estate) that aligns with your risk tolerance, which helps keep you on track toward your goals.”
Our Process at Kings Path
At KPP, one of our primary responsibilities is identifying that "right" diversified mix of investments for each of our clients.
The process of finding this optimal mix starts with understanding how much "bumpiness" (i.e., risk) a client is willing to tolerate. Once this has overall risk target has been established, we work to identify the combination of underlying risk factors that delivers the highest expected return for the client's desired level of risk. We have found this risk factor approach to diversification to be far more effective than the asset class framework employed by most investors. Research has also demonstrated the utility of the risk factor approach to portfolio diversification.
Bender, J., Briand, R., Nielsen, F., & Stefek, D. (2010). Portfolio of Risk Premia: A New Approach to Diversification. Journal Of Portfolio Management, 36(2), 17-25.
