Diversify to Take the Edge off Swings in Investor Sentiment
American Century Investments
June 7, 2012
The investor sentiment cycle presented here is an excellent investor education tool. In a single snapshot, it captures both the cyclical nature of financial markets and the subjective, emotional response many investors have to those market movements. After all, saving and investing are relevant to the extent that they help us achieve profoundly important personal goals, such as funding retirement, a child’s education, or a bequest to future generations. Under those circumstances, it is easy to understand why market swings would elicit an emotional response from investors.
A diversified approach to investing may offer a way to smooth out the emotional swings in the investor sentiment cycle. First, building a diversified portfolio requires careful thought and planning around your goals, financial wherewithal, and tolerance for loss, among other important factors. Putting this sort of structure around your investment decisions can be the first step to reining in a purely emotional response to market volatility.
Second, think of diversification as combining assets with contrasting investment cycles together into a single portfolio—anxiety or fear around performance in one asset class may be offset by optimism based on gains in another investment. Said differently, a diversified portfolio of many uncorrelated assets can reduce portfolio volatility—likely making the ride on the market rollercoaster much more tame for investors in a diversified portfolio versus those holding only stocks.
In technical terms, the “amplitude” of the swings in a diversified portfolio would be lower and, therefore, more tolerable. The temptation to buy (sell) at the peak (trough) is significantly reduced, thereby making a diversified approach much more practical and with more of a potential to succeed.
Finally, closely allayed to the notion of diversification is rebalancing—that is, returning your portfolio weightings to their targeted level by selling assets that have done well (grown larger than their target allocation) and buying those that have underperformed (fallen below their target weight). So, for example, when stocks are doing very well relative to other assets, you are likely near the peak of the investor sentiment cycle. Regular portfolio rebalancing would mean you would be selling stocks at that point to buy underperforming assets. This has several benefits:
- You are selling stocks high and buying other assets low.
- You’re selling stocks at the point of maximum financial risk on our chart.
- You may short-circuit some of the negative psychological and behavioral effects typical of declining markets, safe in the knowledge that you had harvested some of your gains and put that money to work in other, more attractively valued assets.
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Rebalancing allows you to keep your asset allocation in line with your goals. It does not guarantee investment returns and does not eliminate risk.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
(c) American Century Investments
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