Traders work on the floor of the New York Stock Exchange during morning trading on Feb. 19 in New York City. (Credit: Michael M. Santiago/Getty Images files)
Markets today are shaped by rapid changes, from trade policies to technological advancements, creating an environment of uncertainty for investors.
The rapid adoption of artificial intelligence-driven technologies, from automation to deep learning, has fuelled significant market gains, particularly in tech stocks. Despite recent shocks such as DeepSeek’s release and United States tariffs, stock markets are still riding two strong years, with valuations soaring.
History shows that prolonged bull markets tempt us to chase what’s been working, often at the expense of sound portfolio construction, and precisely when volatility might begin to increase.
In 2024, investors poured US$1.5 trillion into U.S.-listed exchange-traded funds, many with concentration in the Magnificent 7 tech giants. This hot hand fallacy can look prudent when markets are soaring; however, it can also end in catastrophe during market downturns.
At its core, diversification is about reducing your reliance on any single stock, sector or asset class. This way, your entire portfolio isn’t derailed when the unexpected happens.
It may not offer the immediate thrill of high-growth sectors, but history proves that spreading risk across industries and geographies is the closest thing investors have to a safety net. Furthermore, that diversification can be the difference between a temporary setback and a lost decade when bubbles burst.
Case in point: the Nasdaq’s precipitous dot-com crash in March 2000 took 15 years to recover from. Consider that the average North American spends about 42 years of their life working. Anyone who invested in the Nasdaq in February 2000 would have spent about 36 per cent of their working life waiting just to get back to even.
As AI reshapes industries, as the internet did previously, and tech giants dominate market valuations, there are some parallels to the dot-com era.
The S&P 500’s current cyclically adjusted price-to-earnings (CAPE) ratio, a measure of market expensiveness, is about 38. This is higher even than it was at 2021’s peak before the 2022 correction. Its highest peak ever was back in 2000, when it reached 44.19. Following that, we had three consecutive years of negative S&P 500 returns.
It’s clear that a bull market can keep charging for some time, but it’s also prudent to consider that growth is not a straight line upwards. As Warren Buffett has said, “Be fearful when others are greedy.”
Be fearful when others are greedy
Warren Buffett
How does one participate in roaring stock markets while managing downside risk?
The simple answer again is diversification. And not just stock-and-bond diversification (one need only look back to 2022 for the reason why), but truly comprehensive diversification such as the type practised by pension plans across Canada. This means both public and private assets, real estate, infrastructure and the like.
What does asset diversification deliver for a portfolio? It reduces concentration risk, compresses price volatility, smooths out returns and delivers more predictable results over time.
Non-correlated asset classes perform differently under changing market conditions. Having a diverse portfolio that includes diversification of assets, geographies and sectors historically captures the macroeconomic trend of most markets growing over time.
In addition, it should be less susceptible to narrower risks such as concentration, market timing, geopolitical shocks, inflation and interest rate changes. Again, this can lead to a consistent performance over time.
Consistency and predictability are especially helpful to the average investor’s psychology to help avoid what is known as the Dalbar effect. The well-known Dalbar Report tracks the impact of investor behaviour on their portfolios and has shown that most investors have considerably underperformed their benchmarks over time by chasing returns or selling off during corrections.
This isn’t surprising. Dramatic changes in portfolio value can rattle even seasoned investors. Conversely, it’s far easier to stick to a plan when there are fewer emotional shocks involved, such as with diversified portfolios.
The importance of predictability also cannot be understated for retirees drawing down their portfolios.
Nobody wants to see their registered retirement savings plan or registered retirement income fund drop in value when they’re counting on it for their annual income. If not planned for in advance, these drops can cause investors to choose between realizing the loss to fund their lifestyle or living leanly while waiting on the markets to recover.
The goal of an investment portfolio is to provide some degree of financial independence. Building your life around market ups and downs is arguably not very independent.
There will always be temptation to double down on a rising tide when times are good, but history teaches us that tides recede. Furthermore, the Dalbar effect demonstrates that most investors are not skilled at predicting these tidal flows.
In a time of significant global uncertainty, the best coping strategy is also the simplest one: diversification.
Chris Warner, FCSI CIM CFP PFP, is a wealth adviser at Nicola Wealth Management Ltd., and Simran Arora, FCSI CIM CFP CIWM, is a wealth adviser and portfolio manager there.
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