A lot of financial advisors like to talk about “insurance” for their clients’ investments. Often, however, this takes the unlikely form of highly risky counter-investments.
For instance, an advisor might choose a broad selection of blue-chip stocks. They pay a nice dividend and, assuming they are not too tightly concentrated, are pretty safe from causing a major loss.
After all, quality companies are quality companies. If the market is challenged, typically, buyers rush in to snap up bargains and the good companies rebound.
But a declining portfolio can be hard news for the client, even if the advisor knows stocks are very likely to rebound and head to new highs. So, to comfort the nervous client, he or she will buy an investment expected to move in the opposite direction.
That might be a leveraged fund, something designed to short the whole market.
While there are some narrow instances where that kind of approach might be logical, say, in a taxable account full of low-basis stocks, in a retirement account it’s just asking for trouble.
What happens if the stock market keeps going up instead? The leveraged short position loses money, that’s what!
Owning a diversified portfolio helps you avoid the problems of a reversal in the stock market by mitigating the decline.
Wide diversification is a form of portfolio shock absorber. Yes, your portfolio will decline in face value during a challenging time for stocks. But, it won’t decline by nearly as much as the market itself.
If you’re in a long-term retirement plan, in fact, a decline in stocks is a chance to buy more, while stocks are temporarily “on sale.”
By owning a multitude of asset classes, you are very likely to see other parts of your portfolio appreciate while stocks are temporarily knocked down. In those moments, you sell off some of those temporary gainers and use the cash to buy stocks.
When stocks recover, you steadily sell off the gains to buy the parts of your portfolio that are dragging relative to equities.
And so it goes, selling high and buying low, but never liquidating anything entirely.
In a broadly diversified portfolio there’s just no need to have “portfolio insurance” against a decline. Rather, as you near retirement age, the portfolio becomes less and less volatile by design.
That’s the way college endowments and pension plans manage risk, and it should be the way retirements are managed too. Thanks to low-cost index funds and portfolio science, it’s possible for just about anybody to get that kind of assurance at minimal cost and trouble.