A selloff is a great starting point for thinking about your portfolio

Key points

• Stay calm and focus on diversification: During market downturns, avoid panic selling and maintain emotional discipline. Ensure your portfolio is well-diversified across different asset classes and sectors to manage risk effectively.
  
  
• Rebalance and invest opportunistically: Consider rebalancing your portfolio if it has become too concentrated. Use cash reserves to increase existing positions or find new investment opportunities, particularly in sectors that have been oversold due to panic.
  
  
• Long-term perspective and equity focus: Remember that long-term investments in equities can compound wealth over time. Diversify within equities and gradually shift to bonds as you near retirement to reduce uncertainty. Emphasize low-cost diversification and avoid home bias by investing globally.

The timeless investing lessons

Nobel laureate Harry Markowitz is famous for having said that “diversification is the only free lunch in investing” based on the key insight that investors can achieve higher returns without necessarily increasing risk. When volatility comes back into the market as we have seen last week but certainly this week and equities are down it is a great opportunity to stop and start thinking about your portfolio. Panic is deep feeling all humans have and can quickly kick in when you see your wealth declining. Equal losses and gains have different impact on our emotions with losses triggering much more negative reactions. When your emotions want to take over it is important to step back and think about the many timeless investing lessons. Our options strategist Koen Hoorelbeke has written a good note called How to protect your investments in turbulent times. Some of the most important lessons are:

• Stay calm as no good decisions are made in panic mode
• Check the portfolio and decide whether it has the right diversification (read the next section)
• Consider rebalancing your portfolio if it is too concentrated
• If you have cash you can consider to increase some of your existing positions or find new opportunities (see last section)
• Remember that time in the market is more important than timing the market.
• Focus on why you invest. It is most likely for retirement and you have decade(s) to let your capital compound and recoup losses.

Diversification has many nuances

When we talk about diversification (check out our diversification page with a lot of information on this topic) it is important to understand the nuances. Below we touch on some few potential pitfalls of diversification as it can in fact be suboptimal if done wrong.

• General diversification: The free lunch in diversification is achieved by adding several stocks or asset classes (stocks and bonds) together because when one asset does bad another will do less bad or good cancelling out risk. The portfolio risk, which is how much your portfolio swings from day to day, is significantly reduced by going from one stock to 10-15 stocks. Many individual investors do not have enough money to spread across enough stocks or do not feel comfortable enough to find 10-15 stocks. This problem can easily be solved by placing a significant amount ofyour capital in a passive index fund (mutual fund or ETF) tracking the MSCI World Index. From that single investment you get exposure to the whole market and has effectively solved diversification within your equity investments. Adding a few single stocks to the portfolio increases the risk again, but also the possibility for a return above the market if the investor is both skilled and lucky.
  
  
• Understand correlation: Correlation is the word that everyone uses in portfolio construction. You can read the mathematical explanation here. A simple way to understand correlation if simply how two processes covariate. If two stocks move together with almost the same magnitude (10% and 9% one day and -4% and -3.5% the other day), the stocks are said to be highly correlated. This is what we observe among stocks in the same sector or industry. So all banks move together because they are fundamentally exposed to the same risk factors such as economic growth, interest rate level, and market volatility. Two stocks that covariate a little, such as an utility and a semiconductor stock, are said to be low or even negatively correlated (if they move opposite to each other). This is where the biggest diversification benefit is achieved. This is why general diversification among 10-15 stocks is bad diversification if they are all banking stocks or technology stocks because they are highly correlated. So it is important to spread equity investments across different sectors of the economy.
  
  
• Home bias: You could have satisfied the two criteria above meaning invested in 10-15 stocks and spread across sectors, but still have made a mistake. Many investors feel most comfortable about stocks from their domestic market, also called the home bias. The problem with this is that you limit yourself to a narrow set of stocks and there can be specific country risks that you could diversify away by investing in other equity markets. The home bias was particularly bad for your portfolio before globalisation, but decades of globalisation has reduced some of, but not all, the negative effects from home bias.
  
  
• Age: If you have a long investment horizon (10 years or more) and no immediate needs like buying a new home or car, then diversification across many asset classes could be suboptimal. This is because equities have historically compounded faster than any other asset class, so if you are saving and investing to maximize your wealth for retirement, and you have time on your side, you should mostly be in equities and make sure your are diversified in equities in a low-cost way. As you get closer to retirement bonds should play a bigger role because you want to reduce uncertainty around your wealth.

Selloffs are also good for finding opportunities

Most long-term investors are rarely fully invested at all times. Often their cash balance grows over time because they are saving up for the future. This means that when equity markets sell off it creates not only a vantage point for thinking about once existing portfolio and diversification, but also what new positions could be added. A good starting point for finding opportunities during a selloff is to look at what stocks have fallen the most because those stocks are where future expectations have declined the most. Given selloffs are rarely efficient because investors panic it means that these stocks might have been oversold.

So there are opportunities in those themes that have fallen the most the past week such as bubble stocks, green transformation, payments, nuclear power, new biotech, and semiconductors. You can find all of our theme baskets here. It is also interesting to observe how strong defence stocks have performed through this volatile period. It is a strong testimony to this is by far the strongest theme in the equity market and it will continue to be so as Europe continues to ramp up military spending.