One of the key challenges faced by investors aiming to generate long-term returns with a diversified portfolio is ‘line-item thinking’. This is where we obsess over the success or failure of individual positions, often losing sight of our true investment goals and the principles of sound diversification. A good investment decision is not the same as a good portfolio decision. 

Portfolio objectives are often framed in terms of beating a benchmark or ‘optimising’ for a given level of risk. Neither of these feels quite right. A benchmark-centric approach implicitly assumes that the benchmark is the correct base mix of assets for our requirements; while optimisations that are striving for ‘return maximisation’ within certain parameters suffer from inputting forecasts that we know will be wrong into a system very sensitive to those incorrect forecasts.

Rather I think for most individuals the objectives of our portfolios should be something along the lines of:

To maximise the probability of delivering good outcomes and minimise the probability of very bad outcomes.

It follows that any decision we make regarding our portfolio should be consistent with achieving those aims; and this is where the issue of line-item thinking arises.

What is line-item thinking? It is characterised by these types of behaviours:

– Thinking about the attractiveness of an investment on a standalone basis, or relative to one other asset. (I expect US equities to outperform emerging market equities, so I am overweight).

– Thinking about how an investment will perform in one future scenario. (I don’t think there will be a recession this year, so I prefer high yield to high grade credit).

– Thinking in terms of profit and loss, and whether an individual position ‘added value’. (This position detracted value and therefore was a mistake).

Although line-item thinking can seem reasonable in isolation, it is often antithetical to good portfolio decision making. None of the three examples above really help me achieve my portfolio objectives as described; they may even hinder it.

Positive portfolio decisions can often seem like bad line-item decisions.

Portfolio Neglect 

The principal reason we build portfolios that combine different assets, funds and securities is diversification. The future is unknowable and therefore we want to create a combination of holdings that is resilient to that uncertainty. If we could predict the future, then we would only hold one security in our portfolio.

This brings us to the central behavioural challenge of diversification. Proof of it being effective comes in the form of assets and positions performing poorly (certainly relative to other things that we hold), but we have little appetite for owning stragglers. 

Good diversification is about making choices that we expect to work in a world that we don’t expect to happen.

Line-item thinking exacerbates this problem because instead of considering the role each holding plays in meeting the objectives of our diversified portfolio, we think about them independently  – did this asset, fund or view outperform or not? It works in binary, deterministic terms.

It is always about outcome bias

Outcome bias (our propensity to judge the quality of a decision by results alone) is one of our most pernicious and powerful behavioural failings. We cannot resist assessing portfolio performance after the fact and judging how the different components have fared. The underperformers and idlers are classed as poor decisions that cause us anxiety, while the outperformers are evidence of sound judgement.

This perspective makes sense through a line-item lens, but it is entirely inconsistent with making sensible portfolio decisions. We can quite easily make choices where an individual position performs well, but fails both criteria of increasing the probability of good outcomes and minimising the probability of very bad outcomes (particularly when only observing short-run returns).

The central issue is that good portfolio decisions are designed to make us robust to a range of unpredictable future results; if we do this, by definition, a decent chunk of our portfolio will look ‘wrong’ with the benefit of hindsight.

Our portfolio performance assessments come once a single market or economic path has been charted.  Diversification always feels like a cost because nothing seems uncertain through the rear view mirror. Line-item thinking comes to the fore here – we look at each position, assess its performance and probably focus on the ones that have struggled.

This seems reasonable but is a terrible idea from a portfolio perspective. But what is the alternative? There are three critical portfolio-thinking questions to ask about the performance of individual positions:

– Was the decision reasonable at the time it was made given what we knew?

– Has the asset behaved in a manner that was broadly consistent with expectations / or its role in the portfolio?

– Did the decision meet the criteria of increasing the probability of good outcomes and minimising the probability of very bad outcomes?

Of course, asking people to think less about outperformance / underperformance of any given position is an entirely futile exercise. What’s measured is what matters! But the more that we think in such a manner, the less likely we are to make decisions that are consistent with meeting our overall portfolio objectives.

Line-item thinking is everywhere. Not a year goes by when the last rites aren’t read for a particular type of asset that hasn’t performed well. Bonds, value investing, liquid alternatives, non-US equities…have all come into the crosshairs in recent times.

These types of claims make sense from a line-item perspective, few of them do from a portfolio one. 

Line-Item Duty

Given that it is portfolio outcomes that matter to us, not the ‘success’ or ‘failure’ of any specific position, why is line-item thinking so prevalent? One undeniable reason is simply availability – we see the line items, so we care about each of them – but there is a deep irony here. We like to check that we are diversified by looking at all the underlying holdings in our portfolio (we don’t want to see just a single line in our valuation even if there is plenty of diversification underneath that); but when we can view each of the underlying positions, it inevitably makes us want to rid ourselves of the poor performers.

Our desire to find proof of diversification leads to behaviour where we become less diversified.

Line-item thinking is also easy. Easy to prove and easy to measure. Positions either work or they don’t, and we were either right about how things panned out or we were wrong. Even attempting to explain why we might be happy that certain positions looked to have performed disappointingly, or why a decision that looks like a poor one actually made a portfolio more likely to meet long-run objectives is likely to be met with scorn.

The consequences of line-item thinking

There are several significant and deleterious consequences of line-item thinking:

Increasing portfolio concentration: Removing the laggards and increasing exposure to the winners is an inevitable consequence of line-item thinking – we don’t want to hold positions that are underperforming, so we reduce diversification and concentrate on the things that we got ‘right’. We create portfolios for the known past, not an uncertain future.

Less portfolio resilience: Line-item thinking means that we focus on whether a position is likely to outperform / underperform, rather than consider the role it might play in making a portfolio more robust to certain outcomes. A position that performs very strongly in a future that has a 30% probability of occurring can be incredibly valuable, even if on 70% of occasions it will look like a failure (on a line-item basis). 

Too much risk: Line-item thinking will perpetually bias us towards higher return / higher risk assets. If we have the choice between two assets – we are always likely to favour that with a higher return potential even if it carries more risk and is less diversifying, because from a line-item perspective it is more likely to outperform.   

Too much trading: Over-trading is an inevitable consequence of line-item thinking as we continually trade in and out of assets as they go through their performance cycles. Not only will we trade too frequently, but we will also almost always do it at inopportune times: Why don’t we hold more of that asset that has outperformed everything else in the portfolio, has enjoyed huge tailwinds in recent years and is trading on stratospheric valuations?

—

The more we think about the standalone merits and performance of any given holding or ‘line-item’ in our portfolios, the less likely we are to make sensible, well-calibrated decisions and be appropriately diversified for an uncertain future. 

–

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).