This has been a bonkers week for the stock market. It’s timely to read an essay like the one Ray Dalio published recently Diversifying Well Is the Most Important Thing You Need to Do in Order to Invest Well.
The reason comes down to two principles:
Extreme moves in markets and economies are largely self-correcting, because when they happen, they set into motion adjustments that tend to reverse those extremes
People tend to extrapolate what they have gotten used to. As a result, after an extended period of a certain type of market and economic behavior (a paradigm), it is likely to be “discounted” or “priced in” to the markets.
Combining these two highlights why diversification is most important:
Because of those last two principles combined—and because policy makers tend to move to reverse extremes in the markets and economies—we have big reversals and big paradigm shifts in markets and economies. It is also why having a well-diversified portfolio that is rebalanced to maintain that diversification has a much better expected return-risk ratio than any single investment.