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Buy low, sell high. Everyone knows that.
Keep a diversified portfolio. Everyone knows that, too — right?
People may know these common-sense investment rules, but many do not remember them at important times, most notably when the market is doing very well or very poorly. A number of advisors have told me that they get the most complaints from clients when the U.S. stock market is doing well. In many cases, this is because investors who have a diversified portfolio do not capture the same returns as the hot U.S. market.
Let’s take a hypothetical investment client. When this investor sees that the U.S. market is having a great year, he wants to go all in on domestic stocks and ditch the lesser-performing holdings in his portfolio — international stocks, bonds and so on. This is called buying high.
This kind of investor runs the risk of selling other things while they’re at their bottom (selling low) and then riding the U.S. market down on its next downturn. Then, true to form, the investor sells U.S. market holdings at the bottom and buys whatever the next hot market is at the top.
Dalbar, a financial services market research firm, is known for its 20-year study on investor behavior. Dalbar’s study showed that over the long run, the S&P 500 far outperformed the average investor’s portfolio. Dalbar says this gap can be explained by human nature — the natural impulses we all have to chase what is “hot,” buy at the top and sell at the bottom. Acknowledging this tendency is the reason many people choose to hire an investment advisor.
If Dalbar’s study isn’t convincing enough, the Callan Periodic Table of Investment Returns really drives the point home. You can’t argue with the numbers. The chart shows that the emerging markets sector was the highest-performing sector in eight of the years from 1993 to 2012 — and also the lowest performing sector during eight of those years. If an investor continually bought what was hot and sold what was cold, he would have lost a lot of money over time.
This chart perfectly demonstrates the case for diversification and for the old adage “buy low and sell high.”
Additionally, many studies have shown that a diversified portfolio results in higher returns over long periods of time. If you are investing in stocks, you should be committed to a long-term strategy. You should understand that the short-term performance of any particular asset class is unpredictable, and that ultimately you do best by staying diversified.
So an investor who took the long-term view and bought emerging markets during one of the years when it was the lowest performing sector (2011, for example) would have been handsomely rewarded in 2012 when it became the highest-performing sector.
So here’s the bottom line: Buy low, sell high and diversify.