Diversification, now more than ever

The U.S. stock market is posting declines of more than 15%. The technology sector has reached 20% negative returns. “In troubled waters, fishermen profit,” as the saying goes. For a long-term investor, this indeed represents a buying opportunity, or at least a chance to rebalance the portfolio (if it is justified from a cost and tax standpoint).

The temptation in a high-volatility scenario is to buy specific stocks, names one “knows” are good companies and that should deliver a higher-than-average return going forward.

How good an idea is that? According to the evidence, quite risky. We know with high probability that stock indices deliver good results over the long term. For example, if we look at the last 90 years of data, there are no 15-year windows in which the U.S. stock market has returned negative. This is not necessarily true for individual companies. Of the Russell 3000 Index today, 1 in 10 stocks is 90% below its highs. In fact, historically there are many changes in the benchmark indices (where the most successful companies typically are). In 1958, a company stayed in the S&P 500 for 61 years; today they last 18. Since 1995, 728 names have entered the index, and in the same period 724 have left. Of the stocks in the Fortune 500 in 1955, only 61 remained in 2014. It is not easy to pick winners.

We know that markets in aggregate recover; companies can go bankrupt. Today more than ever, one must diversify.

This column was originally published in the newspaper La Segunda on July 21, 2022 [LINK]