Black swans are all the rage. But rather than focusing on what might happen, staying diversified and sticking to the basics is your best bet for creating long-term wealth.
Everyone seems to be looking for big wins from the markets. Yet time and time again, what's proven to be the best strategy is to take a more conservative, long-term approach with your investments. Too often, if you try to put all your money in one basket, you'll end up with nothing.
Hunting swans
A recent article in the Wall Street Journal observed how an increasing number of investors are looking for ways to profit from an unexpected event, such as a market crash. Known as black swan events, these surprises cause huge amounts of turbulence in the markets, and for most investors who own shares, they can bring big losses in a short period of time.
Some of the strategies people use to cash in on black swan events, however, are exceptionally risky.
Sophisticated hedge funds use securities like index-based derivatives and privately placed investments to try to take advantage of underestimates of "tail risk" in certain markets. Even average investors are getting in on the action, using spread bets or put options to try to protect themselves from a potential downturn.
The article suggests, though, that such strategies are necessary because old-style diversification hasn't worked well recently. Proponents of black swan strategies argue that during the financial crisis, most markets moved downward at the same time, and therefore those who counted on diversification to save them were sorely disappointed.
Missing the forest for the trees
It's entirely possible that black swan-based strategies may be smart long-term plays. If the markets are indeed underestimating the chance of a catastrophic downturn, then investing a portion of your portfolio could indeed be the right thing to do.
Investors like US hedge-fund manager John Paulson, for instance, made a killing taking the unpopular position that a housing bubble would burst.
But focusing entirely on black swan events means taking your eye off the real goal of your investing: to maximise your wealth over the long haul.
It's true that protecting your wealth during bad times is just as important as, if not more important than, maximizing your gains during a bull market. It's true that it can be almost impossible to recover from a big loss.
If you're not careful, though, the protection you try to buy can be so costly that it takes away any chance you have of reaching your goals if the worst-case scenario never happens.
Diversification still works
Those who say diversified portfolios failed during 2008 and 2009 simply didn't own the right investments. Corporate bonds did suffer along with shares. But if you stuck with Treasury bonds in the US or gilts here in the UK, then you saw excellent gains in 2008 to offset the big fall in the FTSE 100 index.
The prospect of a black swan event is interesting and worth thinking about. But if you let it dominate your attention, you'll miss out on smart investing opportunities throughout the market.
In contrast, if you can stay focused on the big picture, you'll be more likely to reach all of your long-term investing goals.
More on the economy and the markets:
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> A version of this article, written by Dan Caplinger, was originally published on Fool.com. Bruce Jackson has updated it.
