In my last post titled Disciplined Investing, I wrote about the importance of having a well-defined investment approach. Such an approach must be rules based and robust. The importance of discipline, consistency, and clarity is paramount in preventing oneself from making emotion-based decisions. A disciplined investment approach becomes particularly important when uncertainty and volatility dominate the headlines.
Yet discipline, while critical, may not be enough. Even the most disciplined and grounded investor could tumble when the markets offer minimal or no rewards for prolonged periods. That is when diversification becomes indispensable.
S&P 500 Index from 2000-2010
In the decade between January of 2000 and November of 2010, the S&P 500 (SPX) one of the most widely followed stock market indices, delivered a negative annualized compound return (CAGR) of -0.18%, with a volatility of 16.6%, and a maximum drawdown of more than 50%. The chart was eye-catching because it illustrated that an investor in the SPX index beginning in January of 2000 made no money in over a decade and in fact that investor lost money. Despite enormous resilience to endure two bear markets and commensurate volatility, the approach of solely investing in the index took that investor nowhere.
S&P 500 Index Drawdowns from 2000-2010
For most investors, it was a decade of pain, doubt, and stress. Not many investors can endure losing more than half of their investment portfolio. Some lost it all.
The S&P 500 chart above serves as a reminder that markets behave in cycles and can experience prolonged periods of underperformance and even losses. It is during these periods when the market stagnates that diversification and adaptability become critical and your conviction and discipline are repeatedly tested.
In today’s digital world, full of financial influencers, investing advice has become easy to access and easy to follow. The simple solution for financial success: “Just buy an S&P 500 ETF and hold it forever. You will be a millionaire at age 65.” While the advice is practical and promising, it also assumes that history will repeat itself. If history is to repeat, market cycles are bound to change. Even though buying an S&P 500 ETF is an efficient way to gain exposure to the U.S economy, the index is not immune to prolonged periods of stagnation as seen above. Therefore, “stocks always go up in the long run” can become a much more difficult adage to follow as the long run can extend further than most investors anticipate. More importantly, it can extend much farther than what most can emotionally and financially endure. “Buy and hold” is in fact more easily said than done.
Consequently, building a sound investment approach that can be followed demands more than following simple advice. It requires structure, discipline, and a strategy designed to tolerate changing market environments. Diversification, despite being mentioned broadly, is more than owning a piece of 500 different stocks or sectors that all tend to behave in the same way. True diversification involves investing in assets that can behave differently from each other when it matters the most. The goal is not to outperform the long-term returns of U.S. stocks. The goal is to reduce volatility, limit large drawdowns, and preserve capital through different market regimes. All this, while allowing investors to comfortably sleep at night.