A selloff is a great starting point for thinking about your portfolio

The timeless investing lessons

Nobel laureate Harry Markowitz is famous for saying that “diversification is the only free lunch in investing”, based on the insight that investors can achieve higher returns without necessarily increasing risk. When volatility comes back into the market and equities are down, it is a great opportunity to stop and start thinking about your portfolio.  

Panic is a deep feeling that all humans experience, and can quickly kick in when you see your wealth declining. Equal losses and gains have different impacts on our emotions, with losses triggering much more negative reactions. When your emotions want to take over, it is important to step back and think about the timeless investing lessons:

• Stay calm, as no good decisions are ever made in panic mode. 
• Check your portfolio and decide whether it has the right diversification levels. 
• Consider rebalancing your portfolio if it is too concentrated. 
• If you have cash, you can consider increasing some of your existing positions or finding new opportunities. 
• Time in the market is more important than timing the market. 
• Focus on why you invest. It is most likely for retirement, and you have decades to let your capital compound and recoup losses.

Diversification has many nuances

When we talk about diversification, it is important to understand the nuances. Below we touch on a few potential pitfalls of diversification, as it can in fact be suboptimal if done wrong.

• General diversification: The “free lunch” in diversification is achieved by adding several stocks or asset classes (e.g., stocks and bonds) together because when one asset does poorly, another will do better. Portfolio risk—how much your portfolio swings from day to day—is significantly reduced by going from one stock to 10-15 stocks. Investors can easily achieve this outcome by placing a significant proportion of their capital in a passive index fund (mutual fund or ETF) tracking the MSCI World Index. From that single investment, you get exposure to the whole market and effectively achieve diversification within your equity investments. Adding a few single stocks to the portfolio increases risk, but also the possibility for a return above the market if the investor is both skilled and lucky.
  
   

• Understand correlation: Correlation is the word that everyone uses in portfolio construction. A simple way to understand correlation is simply how two processes covariate. If two stocks move together with almost the same magnitude (10% and 9% one day and -4% and -3.5% the other day), the stocks are said to be highly correlated. This is what we observe among stocks in the same sector or industry. For example, all banks move together because they are fundamentally exposed to the same risk factors such as economic growth, interest rate level, and market volatility. Two stocks that covariate little, such as a utility stock and a semiconductor stock, are said to be low or even negatively correlated (if they move opposite to each other). This is where the biggest diversification benefit is achieved. This is why general diversification among 10-15 stocks is bad diversification if they are all banking stocks or technology stocks, because they are highly correlated. It is critical to spread equity investments across different sectors of the economy.
   

• Home bias: Many investors feel most comfortable about stocks from their domestic market, known as home bias. The problem with this is that you limit yourself to a narrow set of stocks, with all their associated specific country risks. Investing in other equity markets can significantly reduce this risk.
   

• Age: If you have a long investment horizon (10 years or more) and no immediate needs like buying a new home or car, then diversification across many asset classes could be suboptimal. This is because equities have historically compounded faster than any other asset class, so if you are saving and investing to maximise your wealth for retirement and have time on your side, you should mostly be in equities (and make sure you are diversified in equities in a low-cost way). As you get closer to retirement, bonds should play a bigger role because you want to reduce uncertainty around your wealth. 

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Selloffs are also good for finding opportunities

Most long-term investors are rarely fully invested at all times. Often their cash balance grows over time because they are saving up for the future. This means that when equity markets sell off, it creates not only a vantage point for thinking about one’s existing portfolio, but also the new positions which could be added. A good starting point for finding opportunities during a selloff is to look at what stocks have fallen the most, because those stocks are where future expectations have declined the most. Given selloffs are rarely efficient (because investors panic), it means these stocks might have been oversold.

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