We tend to judge the outcomes of our investments in binary terms. We make money or lose money. We outperform or underperform. Our judgement was good or it was bad. This type of thinking is flawed because of the role of luck in financial markets. If I make a decision when the odds and evidence are heavily in my favour and it doesn’t work out; that doesn’t make it a poor decision. A small dose of randomness can heavily dilute the information provided by outcomes alone. But there is something else. A prudent investment approach means making certain decisions that you expect and hope to disappoint.
The need for investors to diversify is often framed as a means of smoothing investment performance or tailoring a portfolio to a specific appetite for risk. Whilst this is true, it is not enough. Diversifying across a range of assets or securities is an acceptance that we cannot predict the future and that we will be wrong about many things.
The more confident we are, the more concentrated our investments. With perfect foresight we would only invest in one security. If we want to understand an investor’s confidence, check their portfolio concentration.
Appropriate diversification means always holding some assets and securities that appear to be laggards. This is the intended result. We can think of such positions as failures or costs. Alternatively, we can consider them to be holdings that would have fared better in a different scenario to the one which transpired*.
As investors we all have opinions on markets, stocks and funds. Diversifying our risks appropriately is challenging because it forces us to make decisions not only that we think are likely to be wrong and costly, but that we want to be wrong and costly. This is difficult to justify to ourselves, let alone others. It is tough to tell a confident story about our view of the world, and then make investments that seem contrary to it.
“So, you have just told us there might be an inflationary problem around the corner, why are you holding nominal government bonds?”
“Well, I might be wrong and there could be a deflationary problem around the corner”.
That’s a hard sell.
Let’s make a bet. There is $100,000 on offer. You have to decide what will produce the highest return over the next decade. Emerging market equities or US equities. You have to allocate the $100k between the two options. You will receive the amount you stake on the strongest market. If you are supremely confident, you can put it on a single outcome and risk losing the entire amount. If you are ambivalent you can split it equally and guarantee $50k.
Most investors will have a view on this choice. Some more forthright than others. If you had a strong disposition towards US equities, how aggressive would your stake be? Given the huge uncertainty surrounding the result it makes little sense to go all in. You need to diversify and put money on both. This means allocating money to something that you think is wrong and want to be wrong. It is sensible and prudent, but uncomfortable.
If you wager $70k on US equities and they outstrip emerging market equities, how do you feel? You are likely to curse your conservatism, rather than think about the other possible paths taken. You were right, why didn’t you back yourself more?
After the event, diversification only feels gratifying if we were wrong. If we were right it feels like a cost. If I bet each-way on a horse that wins a race, I will rue the fact that I didn’t bet solely on a victory.
As always, the most challenging aspects of these types of decisions are when it involves changing our mind. Let’s expand on the emerging market versus US equities bet. Five years in and the returns from both markets are identical. You are asked if you want to adjust your stakes. As you have some new information, you still favour US equities but now have less confidence in your view. So you alter your bet to $60k US equities / $40k emerging markets.
You have made a decision that you explicitly want to be incorrect. At the end of the ten year period, it is in your interests if you were to look back and regret making this choice. The level of cognitive dissonance here is pronounced. I prefer US equities but I am reducing my bet. I am making a decision and I want it to cost me money.
The central problem here is that when we are making an investment decision there are a huge range of potential, unknowable paths. After the event, only one route has been taken and a binary judgement will be made – were you right, or wrong? To make matters worse, everyone now feels that the result was obvious at the time you made your decision.
Sensible investment is not about predicting a single path and trying to maximise your returns if it comes to pass. It is about ensuring that you are appropriately positioned for a reasonable range of outcomes. By all means have a view, but it needs to be heavily tempered with an acknowledgement that the future is inherently unpredictable.
How often do you hear this phrase?
“Based on the information you had at the time, that seemed a sensible decision – even if it didn’t work out”.
In life? Rarely, In financial markets? Never.
The best investors are those that are well-calibrated. They understand what they don’t and cannot know. Their decisions reflect this. In simpler language they are comfortable making choices that they feel are wrong and that they hope come with a cost.
*This doesn’t absolve us from investing mistakes.