Ben Carlson has a good post on his site about the reality of investment losses. In essence, you’re going to suffer periods of poor performance in the short-term. Learning to deal with these losses are essential to sticking with a process and a plan. And having a process and a plan are crucial to long-term success. But there’s more to the story here. Learning to lose isn’t just part of market cycles, it’s essential to good asset allocation.
I was talking to a potential client last week who boasted about his current positions which didn’t show a single position in the red on that day. I didn’t say anything, but I thought to myself: “well, that’s probably a sign of a poorly diversified portfolio”. This might sound strange, but it’s when everything is working that I most often get alarmed. The reason is a bit counterintuitive, but a crucial piece to broader portfolio success. You see, when a portfolio’s components are 100% correlated it generally means that you’re not very well diversified. And if you’re not diversified then you’re probably taking a lot more risk than you think.
The reason why this is true is because high beta positions tend to become increasingly correlated when we most need our portfolios to become uncorrelated. For instance, when we look back at the financial crisis we can see that stock losses were undiscriminating. That is, it didn’t matter if you were allocated in healthcare stocks, utilities, tech stocks or dividend paying stocks. When the market panicked equities as a whole were taken down substantially because equities are naturally high beta relative to other safe assets like bonds and cash. By having some cash (usually t-bills in a brokerage account) and bonds in a portfolio you actually smoothed your returns during the crisis. You traded some potential upside in return for predictability.
The unfortunate reality about trading higher returns for greater predictability is that you have to learn to be a good loser. You have to accept the reality that your neighbor who is leveraged to the gills in tech stocks will outperform you handily when things are going well. You have to accept the reality that you will open your portfolio at times and see red positions. You have to accept the reality that the S&P 500 will often outperform your portfolio. But you also get to know that, over the course of a volatile market cycle, your savings will be allocated in such a manner that you will have created greater predictability about how much of that savings will be actually be there at certain times when you might need it. Therefore, by learning to accept losses you actually increase the odds that you will achieve your financial goals.