Insights · Letter No. 7 · Portfolio
Risk, diversification, and sleeping well
Diversification is the only free lunch most investors will ever be offered. What it protects against, and what it does not.
Risk in investing is not one thing. There is the risk that a single company fails, the risk that the whole market falls, the risk that inflation quietly erodes cash, and the very personal risk that you will need money at the exact moment prices are low. Good planning starts by naming which risk you are trying to manage.
Two kinds of risk
Company-specific risk is the chance that one business stumbles: a failed product, a fraud, a lawsuit. Owning many companies across industries largely diversifies it away. Market risk is the chance that most assets fall together, as in a recession or financial crisis. Diversifying across stocks does not remove it. Holding different asset classes, such as bonds and cash, and having a long time horizon, help you live through it.
What history shows
Broad U.S. stocks have produced strong long-run returns, but with deep interruptions. The S&P 500 fell more than 50% from its 2007 peak to its 2009 low, and about a third in a few weeks in early 2020. Investors who could hold through those drops were eventually rewarded; investors forced or frightened into selling locked in their losses. Past performance does not guarantee future results.
Asset allocation
The SEC's investor education office describes asset allocation as dividing a portfolio among categories such as stocks, bonds, and cash, and calls it one of the most important decisions an investor makes. Broadly:
- Stocks have offered the highest long-term growth, with the largest swings.
- Bonds have usually been steadier and provide income, with their own interest-rate and credit risks.
- Cash is stable in dollars but tends to lose ground to inflation over time.
The right mix depends on your time horizon, your need for the money, and your honest tolerance for watching a balance fall. A longer horizon can generally absorb more volatility.
Rebalancing
Over time, winners grow into a larger share of a portfolio, quietly raising its risk. Rebalancing, periodically trimming what has grown and adding to what has lagged, keeps your mix where you intended. It also enforces a gentle discipline of selling high and buying low.
A calm test
Imagine your portfolio is down 30% next year. Would you hold, add, or sell? If the honest answer is "sell," your mix may be riskier than you can live with. The best allocation is the one you can keep through bad years.
This letter is general education, not a recommendation to buy or sell any security. Consider your own situation, and a licensed professional, before making financial decisions.