Investment Shock Absorbers – An interesting analogy from our friends at Dimensional Fund Advisors

Investment Shock Absorbers – An interesting analogy from our friends at Dimensional Fund Advisors

by George Holland on March 4, 2017 Uncategorized

Ever ridden in a car with worn-out shock absorbers? Every bump is jarring, every corner stomach-churning, and every red light an excuse to assume the brace position. Owning an improperly diversified portfolio can trigger similar reactions.

In a motor vehicle, the suspension system keeps the tires in contact with the road and provides a smooth ride for passengers by offsetting the forces of gravity, propulsion, and inertia.

You can drive a car with a broken suspension system, but it will be an extremely uncomfortable ride and the vehicle will be much harder to control, particularly in difficult conditions. Throw in the risk of a breakdown or running off the road altogether and there’s a real chance you may not reach your destination.

In the world of investment, a similarly bumpy and unpredictable ride can await those with concentrated and un-diversified portfolios or those who constantly tinker with their allocation based on a short-term rough patch in the markets.

Of course, everyone feels in control when the surface is straight and smooth, but it’s harder to stay on the road during sudden turns and ups and downs in the market. And keep in mind the fix for your portfolio breaking down is unlikely to be as simple as calling a tow truck. For that reason, the smart thing to do is to diversify, spreading your portfolio across different economically non-correlated asset classes. That also means identifying the right mix of investments that aligns with your risk tolerance, which helps keep you on track toward your goals. Using this approach, your returns from year to year may not match the top performing asset class, but neither are they likely to match the worst. More importantly, this is a ride you are likelier to stick with.

If you’ve ever taken a long road trip, you’ll know that conditions along the way can change quickly and unpredictably, which is why you need a vehicle that’s ready for the worst roads as well as the best. While diversification can never completely eliminate the impact of bumps along your particular investment road, it does help reduce the potential outsized impact that any individual investment can have on your journey.

With proper diversification, the jarring effects of performance extremes level out. That, in turn, helps you stay in your chosen lane and on the road to your investment destination.

Happy motoring and happy investing.