Lesson 1 from 2020: The Power of Diversification
The first investment lesson from 2020 is diversification. Everyone knows that it is important to diversify in order to stabilize your portfolio. In more technical speak, this means holding some assets that tend to zig when other holdings zag To accomplish this, many investors hold long-term bonds. This is something we have recommended to some of our clients prior to 2021 (we currently do not). These bonds, especially government bonds, have a small tendency to move in the opposite direction of stocks.
Government bonds demonstrated this behavior in the first quarter of last year. It was one of the best quarters for long-term bonds. By the end of quarter, long-term government bonds had risen more than the S&P 500 index had lost. The figure below shows a portfolio initially consisting of 50% S&P 500 and 50% long-term government bonds, and you can see it has far less volatility than the two investments.
By the way, remembering back to Q1 2020, did you see any headlines about the fabulous performance of bonds? Probably not. The investment media likes to focus on the dramatic, which at that time was the drop in equities. This underscores an important side point: Watching investment news too closely can make one surprisingly less informed.
The Power of Time
The second investment lesson from 2020 is patience. Waiting is hard. Especially when the market is down a great deal. But waiting is one of the most powerful investment tools.
One of our mantras is Time Eats Volatility. We can demonstrate this mathematically: returns tend to grow proportionately with time, but volatility grows in proportion to the square root of time (slower). This means that over time, returns should outgrow the volatility, reducing the long-term chances of losses.
Fortunately, we saw in 2020 that returns gradually increased for equities for a net gain on the year. However, sometimes this recovery can take several years. This underscores the necessity to let time do its work. We must accept and expect losses.
Many investors are not aware how common losses are. On a daily basis, the odds of losses in the S&P 500 are around 50%. Over a 1-year period, the odds drop to about 1 in 3. Even over a ten-year period, losses are possible, though infrequent, in the S&P 500. Thus, patience is necessary over several years.
Failure to be patient can dramatically increase risks. Reacting is human nature, but often time is the best medicine.
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