Every morning as I drive into the office, I see my fellow commuters darting from lane to lane, trying to choose the fastest one. The problem is, traffic in the “fast” lane inevitably slows down as cars crowd into it, and the slower lanes suddenly become the place to be. So in the long run, despite their risky maneuvers, these drivers don’t usually get much farther ahead than anybody else.
This same mentality can plague investors as well as commuters. When an asset class accelerates, investors pile in. When it slows down, investors bail out. Instead of buying low and selling high, these investors often experience the opposite.
Luckily for investors, they have an advantage that commuters don’t. While drivers can only be in one lane at once, investors can spread their portfolio over a wide range of asset classes. That’s called diversification.
Why is diversification important?
Many investors believe they can react to market and economic events as they unfold, so they don’t prepare in advance for events that they don’t believe are imminent — whether it’s recession, inflation or even a bull market in stocks. But history has shown us that market and economic events are not always easy to predict, and a sudden movement in the market could have a catastrophic impact on a portfolio if you’re not ready for it. Diversification means being prepared for a variety of economic possibilities.
How can investors be prepared?
Now, that leaves us with the question — how do you prepare a portfolio for various economic environments? First, let’s take a quick look at some history. Here, you can see exactly how major asset classes have performed in different economic environments.
- Bonds led the way in the deflationary environment of 1929 to 1941, and again from 2000 to 2014, when credit supply reductions created a deflationary-like environment.
- From 1966 to 1981, cash, represented by T-Bills, outperformed stocks — and both of those assets trailed the inflation rate. When you carve out the period of starting in 1973, when the commodities index was launched, you can see that commodities led the way for nine years and were the only asset class that provided meaningful returns above inflation.
- Stocks led the way during the two bull markets of 1942 to 1965 and 1982 to 1999.
What’s the lesson we can take from this chart? A well-diversified portfolio should include a mix of assets that perform differently in various economic environments — that way, investors are ready for what may come.
Under this framework, the concept of investing is pretty simple: Invest in stocks for their growth potential, but also make sure you’re prepared for two major risks that can derail that growth: inflation and deflation. To stay ready for inflationary environments, talk to your financial advisor about commodities, direct real estate or Treasury inflation-protected securities (TIPS). To be prepared for deflationary and recessionary environments, talk to your advisor about bonds.
Unfortunately, there’s not much you can do to make traffic flow better on your way to work. But with a well-diversified investment portfolio, you can help ensure that when one asset class slows down, your other holdings are driving you toward your financial goals.
Important information
Diversification does not guarantee a profit or eliminate the risk of loss.
In general, stock values fluctuate, sometimes widely, in response to activities specific to the company as well as general market, economic and political conditions.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest.
The S&P 500 Index is an unmanaged index considered representative of the US stock market.
The CPI is a measure of change in consumer prices as determined by the US Bureau of Labor Statistics.
The S&P GSCI Index is an unmanaged world production-weighted index composed of the principal physical commodities that are the subject of active, liquid futures markets.
The Ibbotson U.S. Long-Term Government Bond Index is an unmanaged index representative of long-term US government bonds.
The Ibbotson U.S. 30-Day T-Bill Index is an unmanaged index representative of 30-day Treasury bills.
The Ibbotson U.S. Long-Term Corporate Bond Index is an unmanaged index representative of long-term US corporate bonds.
The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals.
All data provided by Invesco unless otherwise noted.
Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd.
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Diversification: A better way to avoid portfolio gridlock by Invesco Blog
