Investors often remark that the world economy has changed and that it’s more volatile than ever. They are less trusting of stock markets and they don’t want to take risk.
I can’t say I blame them. I might ask though, if the world has changed, if it is more volatile, “how are you changing the way you invest to protect your portfolio?” Doing the same thing will surely get the same result.
In reality, most investor portfolios are a collection of investments accumulated one good idea at a time – year after year. How many of these investments are decided over the telephone in a short conversation? How does this approach protect you in an increasingly volatile economy? Managing your portfolio “one good idea at a time” adds unnecessary risk that is specific to individual companies or industries. Portfolios, even mutual funds consisting of a small number of stocks or concentrated in specific industries, are vulnerable should a favoured company become obsolete, lose a major customer or supplier, experience an unexpected shutdown or an internal fraud, or witness any other number of value-crushing events.
This added risk is uncompensated because on average investors don’t receive any extra return for exposing their portfolio to it.
Uncompensated risks that should be diversified away include:
- Single-security risk (holding too few securities)
- Concentrated holdings (betting on industries or countries)
- Reliance on analysts’ research (predictions)
- Reliance on economic forecasts (predictions)
- Reliance on credit ratings agencies (predictions)
- Reliance on mutual fund ranking systems (predictions)
- Market timing (predictions)
The investment industry sells predictions about the potential best stocks or securities. This leaves portfolios vulnerable to human errors of judgment and the unfortunate reality that good companies sometimes fail. Think of all the investors who owned the common shares, preferred shares, or bonds of one of these formerly great companies: Enron, Lehman Brothers, Citigroup, WorldCom, Research in Motion, and Nortel.
Single-security risk is uncompensated and should be diversified away. The solution can be simple. Buy an index fund i.e. a fund that holds the market portfolio. Market index funds eliminate the risk of individual stocks and the risk of specific industries, and remove the need for predictions. These index funds avoid uncompensated risks, and save your portfolio from losses.
Investment losses are different from market declines. Losses don’t come back.
If you would like more information or have any questions, feel free to contact us at 780.466.6204, or click here to email us.
Thanks to Chris Turnbull of The Index House for providing much of this content.
The Index House is a division of Polaris Financial Inc.