I have no idea what happened in financial markets in the second quarter of 2019. I think it is safe to assume that not many people do. The problem is that when we were living through it, it would have felt like the most important thing. As if the ‘information’ we were engaging with would have a profound impact on our investment outcomes. Yet now we cannot even remember it. Our obsession with dealing with what is right in front of us may well be an effective evolutionary adaption, but it is a terrible affliction for most investors with long-term goals.  

Human attention tends to be drawn towards two things – salience and availability. Salience is where something is particularly noticeable (often due to some emotional resonance), and availability is how easily something comes to mind (typically because it is recent). The lure of the day-to-day gyrations of financial markets is strong.

Unfortunately, it is not only an issue of attention, but importance. We are prone to hugely overweight the relevance of what is happening in the moment, as Daniel Kahneman noted:

“Nothing in life is as important as you think it is, while you are thinking about it.”

In the general sense this is not irrational human behaviour. If something is happening or changing in the current instant, then it can make absolute sense to focus on it and deal with it immediately. Taking the time to accurately calculate the probability of whether that movement you spotted on the savannah is actually the head of a lion is probably not a smart strategy. The issue is that rationality is context dependent. What is good for human survival is often terrible for long-term investing.

The problems that stem from this behavioural wiring are twofold. First, we are likely to neglect information that is genuinely important in favour of what we are currently experiencing. Second, we are almost certain to trade too much as we get stuck in the cycle of continually reacting to the next set of salient and available information, or what we might instead call the prevailing market narrative.

That most investors are caught in this behaviourally satisfying but return-eroding loop is reflected in the lack of introspection or reflection around past decisions and opinions. Nobody looks back at all the predictions that were made in our market outlooks for 2019 because it would be embarrassing to acknowledge how wrong we were and how attentively we focused on matters that were either irrelevant or unpredictable. It is better for everyone if we all just keep looking forward.

Escaping this damaging obsession with the present is not simply about overcoming our own behavioural limitations but acting in a manner that is contrary to expectations. It is not just us who feels that we must do something about what is happening right now. Everyone does. Even if we don’t think it is important it makes sense to act as if it is. In this instance taking action is still about survival, but not from the lion, in our job.

There are inevitably periods in time when there are market developments that matter for our long-term prospects. These might be fundamental (such as some significant change in valuations or expected returns) or behavioural (dealing with these challenges of bear markets and bubbles), but will be dramatically outweighed by things that are either unimportant or unforecastable. 

When we are living with markets in each moment it is almost impossible to separate signal from noise because of the undue status we place on the present. Aside from entirely ignoring the vacillations of markets (which for many is impossible), the only conceivable way to deal with this is to define in advance what aspects are important and then attempt to ignore the rest. This is the price of admission for the advantages provided by a long-term investing approach. Nobody said it was easy.

Attempting to be a long-term investor while obsessing over the short-term fluctuations of financial markets is like starting a diet but filling your kitchen with chocolates and cakes; you might still achieve your goals but you are really making it hard for yourself. 

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

Harry Markowitz is reported to have said that “diversification is the only free lunch in investing”. This is the notion that holding a broader range of assets can result in better returns without assuming more risk. Over the decades this has become accepted wisdom – but it is not true. Diversification isn’t free; it is painful and difficult to achieve.

Diversification is a vital concept for investors. It is an acceptance that the future is inherently unknowable and can take many different directions. If done well it provides protection against both uncertainty and hubris. The best indicator of an investor’s overconfidence is how concentrated their portfolio is. If we could accurately predict the future, then we would only own one security.

Given this, why is diversification a problem?

Because it is behaviourally difficult. To be appropriately diversified not only means holding assets that will be a disappointment, but where we actively want them to disappoint in advance.

If everything is performing well and in concert, our portfolios are probably not diversified.

If we are appropriately diversified, we will look at our portfolio and see a collection of strong performers and laggards. Rather than be comfortable with this as an inevitable feature of diversification however, we will have the urge to make changes. Removing the struggling positions and adding more to those that have produced stellar results.

It is far more comfortable for our portfolios to be focused on the top performing assets rather than be genuinely diversified. It will feel like there is nothing to worry about – everything is working well. Although we are drawn towards this type of situation, it is merely a short-term complacency that will foster almost certain long-term pain.

Diversification is constantly put in jeopardy by our behavioural failings. For the assets that are outperforming in our portfolios, the prevailing market narratives will persuade us that this environment will persist forever. Conversely, the stories around the stragglers will make us believe that they will never deliver again.

When we are reviewing the performance of our portfolio, diversification often feels like a bad idea – because we could have always held more of the assets that provided the highest returns.

Hindsight makes diversification look unnecessary.  

Given that maintaining appropriate levels of diversification is likely to prove a constant challenge for investors, there are two crucial concepts to place at the forefront of our thinking:

– Things will be different in the future: Markets are constantly adapting, things will be different in the future in ways that we are unable to predict.

– Things could have been different in the past: When we look at the performance of our portfolios, we assume that it was inescapable that this particular course had been charted, but, of course, this is never the case. In a chaotic, complex system, entirely different outcomes could have come to pass.

Diversification requires us to own positions that haven’t performed well and we don’t expect to always perform well. That doesn’t mean we should naively hold any asset irrespective of its fundamental characteristics, but we must accept that to be well-diversified requires us to have relative slackers in our portfolios at all points in time.

Nothing that works in investing provides a free lunch, it always comes with some behavioural pain. For diversification it is the acute sense of regret about how much better things could have been.  

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).