What a great title for a marketing piece. I’m not sure who came up with the name, but it’s direct and to-the-point, is it not? It’s a simple concept really: create a timeline over the past few decades or so and point out those events that frighten people along the way. For example, WWII, the Cuban missile crisis, inflation in the ‘70’s, the crash of ’87, the Asian contagion, the crash of 2000-2002, the ’08 crash and so on. These are but a few examples of events that caused investors concern, and who can blame them? This particular timeline isn’t a straight line however. These events are superimposed on the Dow Jones Industrial Average or the S&P 500 to illustrate one message: that despite the constant presence of reasons NOT to invest, markets have gone in one direction over time, up. Why is that?
My goal is to change the way you think about financial markets in general, and diversification specifically. I promise this won’t be too wonky…we’ll leave that to the academics. Here are two basic truths you must accept in order to have a successful investment experience:
1. Capitalism dictates a positive return on the investor’s dollar. Why? There are four components in a successful capitalistic model.
• Natural Resources
• Intellectual capital – those with ideas; leadership
• Human capital – those who make the idea a reality; skilled labor
• Financial capital – investors that fund the enterprise (buy materials, pay workers, etc.) The first three inputs in a market economy create wealth. As investors providing the financial capital, you are entitled to your share of that wealth. (With thanks to Dan Wheeler for this example)
2. Diversification is the only free lunch in investing. Risk and reward go hand in hand. If you wish to limit your risks, you must accept that you limit the potential for gain. If you wish to enhance either your ability to make higher returns or insure yourself against losses, typically you will pay for that in the form of higher fees. Diversification on the other hand, costs nothing and helps protect against losses by not having all of your eggs in one basket. Many in my business write about low risk and high reward but they are just salespeople. Those of you reading this thinking you’ve been shown a way to make high returns with little risk are about to be ripped off.
So what makes the timeline so effective? It illustrates that a diversified portfolio of stocks has delivered a positive return over time. It shows that even through unimaginably bad times, the markets come back after the “news” has been consumed and processed. Realizing this positive return takes knowledge and discipline. The knowledge that markets, while not perfect, work quite well over the long run. Discipline however, is tough – you must either learn it on your own or find an advisor or coach that will keep you from making emotional decisions at exactly the wrong moment in time. It has been my experience that discipline breaks down for investors in the midst of bear markets (crashes) and even at times during a roaring bull market (think the tech bubble). Most of us have strong emotions where our money is concerned and this is what causes us to make poor decisions. I believe that one of the most valuable services a good financial advisor provides is the ability to say “no” to a client. They are the discipline the client lacks regarding finances.
Perhaps the biggest risk even informed, disciplined investors take is sequence of returns risk. There are two phases of your investment life: accumulation and distribution. Sequence of returns risk is experiencing a sharp downturn right as you enter the distribution phase of life – living off of your retirement savings. I will discuss this in my next entry…stay tuned.