SOUND VIEWS – Q2 2023 Diversification and Volatility

In the past issue of Sound Views I covered some basics around planning and how to prepare yourself for changing markets. Building on the theme of education, I thought it best to talk through the things that go into a well-designed portfolio. First, we need to review two foundational concepts that apply for any investment discussion: diversification and volatility.

Many investors are familiar with the concept of “don’t put all your eggs in one basket” which refers to diversification. The idea is that by owning more than one investment, something should always be working in the portfolio. I think a better analogy is a paned window. When you have a multi-paned window, one or two panes might break, but hopefully the other pieces stay intact long enough for you to repair the rest of the window.

This is a more realistic depiction of how diversified portfolios work over time. There will be years where several investments do poorly while others do very well, for example stocks last year. That doesn’t mean you shouldn’t own them.

Over long periods of time, stocks have added to the return. You just want something in there to work while stocks are not. We believe that holding investments with low historical relationships can help smooth your overall return. Notice that I didn’t say a necessarily higher return. When you’re invested for long-term goals, the path of your returns matter and having a smoother ride can help keep you on track.

Regarding volatility, you have most likely heard at some point when turning on the news, “stocks had a volatile session on ‘Wall Street.’” It’s really a way for the talking heads to avoid using the word loss. They focus on the downside but it technically applies to the upside of the market as well. From a portfolio management perspective volatility measures the expected change in an investment or portfolio over a given period of time (1 day, 1 month, 1 year, etc.). It’s a useful tool to help us evaluate the riskiness of our investments, even if the estimates aren’t always reflective of reality. We think that by trying to limit volatility where we can, it will increase our clients’ chances of success over sufficiently long periods, understanding that higher levels of risk may be appropriate depending on personal circumstances.

Like a home cooked meal there are many things that go into a well-designed portfolio. There are many recipes you can follow, and we believe ours has its own unique flavor. We start our process by defining the universe of investments we think are appropriate for investors to own, like picking the ingredients for our dinner. Once we’ve picked the ingredients, we put them in our pot to create the spectrum of risk for our clients. We believe that most investors’ needs can typically be met through one of five primary investment styles. Those styles range from Conservative Income to Aggressive Growth, each holding a mix of at least 3 primary ingredients or asset classes: stocks, bonds, real assets.

  • Stocks – engine for growth
  • Bonds – provide income and stability
  • Real Assets – help protect against things like inflation

We will touch on each of these asset classes in later editions of the newsletter.

Going back to the recipe analogy, changing the mix of these staple ingredients will change the flavor of the meal, but ultimately you still end up with a well-diversified portfolio. Once our long-term portfolio is set, we apply a proprietary method to shift the pieces around and position our clients for the investing road ahead. This is called our tactical process and provides another opportunity to add to your long-term returns. By starting with a basic but robust allocation, aligning it with your individual goals, and applying thoughtful tilts we believe you can have a higher degree of success over your time horizon.

Investing in a well-diversified portfolio is typically not as exciting as buying a hot stock, and it probably won’t make you rich, but like a well-cooked meal it can lead to a smoother experience and prove very satisfying when you need it the most.

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