The S & P500, the index that includes the 500 most important companies in the United States, is the holy grail of the investor. It is an index whose trend is always upward and many investors entrust their portfolio to it, in a simple way: indexing and nothing else.
And although indexing is always a good investment idea, the truth is that what we have seen in the last year is a simple mirage. This brutal rise is not usual and therefore, there have to be corrections at some point. And the key to avoid this correction is not to market timing, as we already advise against these pages, otherwise to diversify.
The falls of the S & P500
You don’t have to look very far to see the S & P500 crash. March 2020 is very well known. From February 10, 2020 to March 16, 2020, the S & P500 fell 30%. In just a month. And yes, the recovery was fast but many investors, not seeing the end to the economic crisis caused by covid-19 exited the market with heavy losses.
Let’s go back to another relatively recent drop, the one that started in 2007. And since we’re going to look at longer periods, let’s talk about the “total return” index, to take dividends into account as well. An investor who entered the market in October 2007 would not have recovered his investment until April 2012. Five years just to get into the green numbers.
But we can go back even a little further, to dot com pre-bubble period. An investor who had entered the S & P500 in August 1999 would not have entered the green numbers until October 2006 (seven years!), But if then he had not left the market and had to also experience the stock market crisis of 2007 and 2008, and until December 2010 I would not have seen green numbers again (more than 10 years!).
Diversify as a foundation
Therefore, although the year we have been here is great in the S & P500 and although the 2010s have been fantastic (385% increase), we must not forget that bad times can come, very bad, with up to 10 years without going back.
The idea behind all this explanation is that it is not a good idea to be exposed only to the S & P500. It is important to diversify. By investing in the S & P500, there is a good diversification of sectors (although technology has a great weight) and also regional (because, although they are US companies, they have a presence all over the world) but it is being ignored asset diversification (You are only investing in listed companies).
Adding other types of assets such as bonds helps cushion the drops and that is why portfolios type or mutual funds always have a certain percentage in bonds and other components that are not strictly stocks.
Subtract potential but avoid risks
It is very true that in the last decade a portfolio based solely on S & P500 would have outperformed any combination of stocks and bonds. Diversifying, on many occasions, reduces the potential of the portfolio. But the objective of this diversification is not to earn more money but to avoid risks. A portfolio with bonds in the 2000s surely would not have been flat and would not have had as much volatility as the S & P500.
We recently commented the permanent portfolio as protection against falls and we already commented that said portfolio (which has 25% shares, 25% gold, 25% cash and 25% bonds) offered a very low volatility in the face of market fluctuations, protecting capital against the stock market crises of 1987, 2000 and 2007.
Perhaps such a portfolio is too conservative, but what it shows is that diversifying helps reduce losses in bad times and that is essential when investing.
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