Savvy investors know diversification is key to managing market risk and exploiting market opportunity. Spreading your exposure across stock categories has many benefits. First, you avoid the risk of being over-concentrated in one category that may undergo a bearish decline. Second, you position yourself to benefit when a new category rises to lead the next bull market trend.
All major categories—style, size, sector or country—will change when it comes to leadership over the course of a bull market. Some leading categories may spend more time in an uptrend than others for any given bull market. But no single category will permanently dominate over time. And the only way to capture this fluctuation in bull trend leadership is to maintain a broadly diversified portfolio. Sadly, many investors and even some professional fund managers are prone to focusing too much on a specific size, style or category of investment. In this article, we’ll talk about common biases that cause investing mistakes.
Because the US accounts for over half of the developed-world equity market, investors may choose to invest only in US stocks. And since many US companies operate abroad, investors may mistakenly think they can kill two birds with one stone—investing in US companies while achieving global diversification through each company’s international exposure.
Regardless of a company’s global revenue sources, their stocks have a much higher correlation to their home country’s market than to any other country in which the company may operate. Therefore, investing in a portfolio of all US stocks can still leave investors under-diversified.
To put it simply, recency bias assumes what worked well in the recent past should work similarly again. Those who fall for recency bias assume stock categories that have outperformed the market recently will continue to outperform in the future. Their bullish market outlook is based on yesterday’s trend.
Although some stock categories behave similarly through bull market cycles, many category leadership changes are difficult to predict. Demand for certain stocks, sectors and even international markets will shift from one to the next. No category can remain permanently a leader permanently. So, relying too heavily on any one category can leave you dangerously under-diversified. And if you select the “hot” stock category too late, you could put your retirement savings at risk.
Heat chasing is focusing on a high-performing stock category and over-concentrating your portfolio on sectors or countries where stocks are trending upward.
As investors pile into these stocks, they run the risk of under-diversification. They miss out on the rising price action of other sectors and, of course, fall victim to the reversal of high-performing stocks.
Here’s an example from recent history:
Toward the end of the 1990s, technology stocks were among the hottest investments on Wall Street. Those who chased this trend toward the end of the cycle ended up getting crushed during the 2000 – 2003 bear market. In the early 2000s, as the bear market got underway, a new category—small cap stocks—gained favor. Then non-US stocks became the market darlings for the remainder of the 2003 – 2007 bull market. Suddenly, investors piled into non-US stocks. The general sentiment was the US was done, an echo of the bearish feeling we saw during the 1980s, right before US stocks led the stock market bull in the following decade.
In short, heat chasing can cost you in the form of potential loss and missed opportunities in other sectors and categories.
No one category can maintain market leadership throughout the various cyclical phases of the economy. Bull market leadership shifts in irregular cycles. The irregular mosaic pattern shown here illustrates the unpredictability of recent market-leading categories, from 1999 to 2018.**
The key to achieving your longer-term goals is healthy diversification. If your portfolio is well-diversified you may benefit from all categories as they rotate into a bull market leadership position.
We are committed to educating investors about the importance of maintaining a diversified portfolio. For more information on how Fisher Investments can help you achieve your long-term retirement goals, contact us.
*** Source: FactSet, as of 15/2/2019; FTSE All-Share, MSCI World Ex-UK, MSCI Emerging Markets (EM), MSCI UK Growth, MSCI UK Value, FTSE 100, FTSE 250, and FTSE Small Cap Total Return Indexes from 31/12/1998–31/12/2018, in GBP. MSCI EM returns from 31/12/1998–31/12/2018 and MSCI World Ex-UK returns are presented inclusive of net dividends; all other returns are presented inclusive of gross dividends. Global Financial Data, as of 15/2/2019; UK 10-Year Government Bond Total Return Index from 31/12/1998–31/12/2018, GBP.