Diversification helps to guard against recency bias

Maintaining a well-diversified portfolio and rebalancing back to your targeted asset allocation – at least annually – helps to keep recency bias at bay (i.e. our natural tendency to chase the winners and sell the losers).

In the chart below, we have used a balanced portfolio (in white) to reflect the performance of a well-diversified portfolio.

Looking at the chart you may be thinking to yourself, “over this period the balanced portfolio has never ‘topped the table’ so why bother”?

The answer is protection. The aim of a well-diversified portfolio is to provide more stable returns over the long term while reducing risk.

That is exactly what the balanced portfolio has achieved over the last 20 years. Returns have been ‘middle of the pack’, never the best, but more importantly never the worst.

A balanced portfolio provides insurance against uncertainty

What is also clear from the chart is that there is a degree of unpredictability when it comes to the performance of markets.

In any given year, there will always be one asset class or sector that performs well and one that lags the others.

And, if a portfolio is not diversified widely enough, or only focused on last year’s winner it would be very easy to miss-out on capturing some of this outperformance.

For example, it would be fair to say that the performance of the US market lagged many other regions and asset classes in the 2000s.

However, in the years following this decade, US equities have performed very strongly.

As such, ignoring the US market due to its underperformance in the 2000s, would have been detrimental to the performance of portfolios.

This strategy would have underperformed a well-diversified portfolio that maintained an exposure to all markets regardless of how they performed in the prior year.

This is an excerpt of an article published for clients only. Craigs Investment Partners clients can view the full version of this article by logging in to the client portal.

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