Has Index Fund Growth Impaired Markets?
One concern about the increasing popularity of index funds is whether the decline in active management has impacted the function of markets.
In our last piece, “Managing the Market’s Risky Business,” we described how diversification plays a key role in minimizing unnecessary risks and helping you better manage those that remain. To round out the conversation, we will cover another benefit to be gained from a well-diversified stable of investments: It helps create a smoother ride toward your goals.
Like a bucking bronco, near-term market returns are characterized more by periods of wild volatility than by a steady-as-she-goes trot. Diversification helps you tame that beast. Because, as any rider knows, it does not matter how high you can jump if you fall out of the saddle.
When we crunch the evidence-based numbers, we discover that diversification helps minimize the bucking you must endure along the way to long-term expected returns. Imagine several rough-and-tumble, upwardly mobile lines that represent several kinds of holdings. Individually, each represents a wild ride. Bundled together, the upward mobility remains, but the jaggedness along the way can be smoothed (albeit never completely eliminated).
Fidelity’s “Guide to Diversification” describes how diversification and individualized portfolio construction can help you tame the market’s best and worst investment outcomes according to your goals. For a more detailed, data-driven illustration of the same, check out “How to Diversify Your Investments” by financial author Larry Swedroe.
A key reason diversification works is related to how different market components respond to price-changing events. When one type of investment may zig due to particular news, another may zag. Instead of trying to move in and out of favored components, the goal is to remain diversified across a variety of them. This increases the odds that, when some of your holdings are underperforming, others will outperform, or at least hold their own.
The result of diversification is not perfectly predictable, but it offers a blanket of coverage for capturing random market returns where and when they occur. This goes a long way toward replacing nerve-wracking guesswork with a more coherent investment strategy.
Diversification offers you wide, more manageable exposure to the market’s long-term expected returns, as well as a smoother expected ride along the way. Perhaps most important, it eliminates the need to try to forecast future market movements, thus reducing those disruptive self-doubts that throw so many investors off course.
So far, we have introduced some of the challenges investors face in efficient markets and how to overcome them with a well-diversified portfolio. Next, we will pop open the hood and take a closer look at how to tune up your own investment portfolio’s performance.
This post was written and first distributed by Wendy J. Cook.
DISCLAIMERS
This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation. This is not an offer to buy or sell a security.
Shore Point Advisors is an investment adviser located in Brielle, New Jersey. Shore Point Advisors is registered with the Securities and Exchange Commission (SEC). Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission. Shore Point Advisors only transacts business in states in which it is properly registered or is excluded or exempted from registration. Insurance products and services are offered through JCL Financial, LLC (“JCL”). Shore Point Advisors and JCL are affiliated entities.
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