Do you remember this public service announcement? “This is a test. This station is conducting a test of the Emergency Broadcast System. This is only a test.”
The Emergency Broadcast System was created in 1963 during the Kennedy administration and used until 1997. If you were watching a show during that time, you knew not to change the channel or adjust the dials on your TV set. (And in the early days, the three or four other channels you could get were all usually conducting the same test anyway.)
Now let’s add a few words and phrases to that PSA in terms of your investments over the past year: “This is a test. This is only a test of your will and patience.”
This past year, most of your investments were flat (at best) and some even lost money. But if you have a well-diversified portfolio, you should not change your investments — and you should certainly not attempt to guess which investments will be the best performers in the coming year. Investing is inherently unpredictable. But as a long-term investor, you must not be swayed by volatility, even when the grass looks greener elsewhere.
In 2015, many investors may have asked, “Am I in the wrong investments?” Well, if your portfolio is well-diversified, probably not. In fact, it’s likely that it was the markets that performed poorly, not your investments. The reasons for that vary, from economic uncertainty in China to the dramatic drop in energy prices and concerns over potentially rising interest rates.
But none of this is unusual. Markets, like many things in life, tend to cycle. They go up and they go down, and we don’t know when they will do so. The markets have had a pretty good run since 2009, so it seems to me that we were due for a flat or negative year (of course we couldn’t know exactly when that might occur).
What to do?
One of my clients recently asked, “Did anything do well?” As a matter of fact, international small companies did pretty well. (For instance, Dimensional’s International Small Cap Growth fund (DISMX) yielded around 10.5% last year.) He then asked me if he owned shares of any of those kinds of companies. I told him that his broadly diversified portfolio has a small portion of international small companies in it.
Then he wanted to know if he should move most of his money into international small companies. I responded with a resounding “No!” Besides being a riskier investment category, international small companies show absolutely no evidence that they will do well again this year.
I asked my client to imagine that he was flipping a coin and trying to guess which flip would result in heads and which flip would result in tails. Of course, after numerous tosses, we agreed that he’d have an even distribution of heads and tails. But, more importantly, we agreed that a coin is an inanimate object with no memory. Just because five flips have landed on heads doesn’t mean that the next flip will land on tails.
I explained that stocks are the same way. They have no memory. There is no guarantee that international small companies will continue to do well next year. Sticking to the discipline of having a broadly diversified portfolio helps us avoid falling prey to the false notion that last year’s best performers will be the winning performers the next year.
Keep it boring
A well-diversified portfolio doesn’t speculate or gamble on what is going to happen next. “Investing should be boring,” I told him. “If you want excitement, try hang gliding. If you want to gamble with your money, go to Vegas.”
So in 2016, resolve to stick with your well-diversified portfolio. If you’re not sure whether you’re diversified enough, have a trusted advisor take a look. But remember, this past year was simply a test of your patience and your will to stay appropriately invested, even when the going gets rough.
(This article was originally published on NerdWallet.com: http://www.nerdwallet.com/blog/advisorvoices/volatility-psa-dont-panic-this-is-only-a-test/)