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Diversification Means Always Having To Say You're Sorry

August 8, 2019

Diversification is unquestionably the anchor to designing an effective portfolio of investments. The idea is commonsense to all of us: Don’t put all of your eggs in one basket.

 

Because we don’t know what’s going to outperform, we spread our bets across a variety of investments. The trick, if it is one, is that we need to consider how the price of each investment varies in relation to the others. Assuming they don’t move in lock step with each other, there is inherent benefit in owning lower-correlated investments. Doing so allows us to hold a more “efficient” portfolio, meaning either: (1) for the same level of risk, we can earn higher returns or (2) we can achieve a similar return level but at reduced volatility.

 

Sounds good! But of course there’s a catch — and one that few have actually commented on. Being truly diversified means that there almost always will be a part of your portfolio that is sucking wind. (Big note: if every piece of your portfolio is working really well, it means one of two things: you’re incredibly lucky or you are not actually diversified. I would assume the latter.)

 

But what’s the big deal about that? Indeed, owning underperformers is built in to the definition. While statistically true, there is an unspoken behavioral component to this experience: We hate owning losers. And we fixate on the negative, drumming up feelings of regret and “if only” I (or my adviser) had tilted more toward fill-in-the-blank.

 

Examine, for example, one of the many “periodic tables” of asset class and key index returns. And now look only at the bottom line of boxes to see the worst of every year. It reads as such:

 

Source: Morningstar Research Inc., December 31, 2018. CDN$

Emerging Markets Equities MSCI EM GRI; Canadian Equities S&P/TSX Composite TR; International Equities MSCI EAFE;  Canadian Bonds FTSE TMX Canada Universe Bond Index† ; U.S. Equities S&P 500 TR; Global Bonds Barclays Global Aggregate Bond TRI ;  U.S. Bonds Barclays U.S. Aggregate Bond TRI.

 

And so forth… And then another quick take on the data: Let’s look at the difference in the top performing investment class versus the bottom in 2017 - The gap was over 30% between emerging markets and U.S. Bonds.

 

Two things are clear. One, a diversified portfolio will often have outright losers in it. Two, the gap between the top dog and the mutt is often very wide. The opportunity to feel regret is frequent. Alas, diversification usually doesn’t feel very good. 

 

2017 was a a good example of this discomfort. Take a diversified balanced portfolio of a 60% Equity 40% Fixed income -The return of this reasonable portfolio in 2017? 8.319%. That’s right, just 8.319%. Plenty of asset classes performed poorly in 2017. The rub is that the S&P 500, by far the most popular proxy for “the market” returned more than 13%. Though that gap of about 7% is small compared to some of the big gaps shown above, many investors still seem to have a sense of frustration over their portfolios.

Balanced portfolio as follows: 5% emerging mkts, 10% int'l equities, 30% US equities, 15% CDN equities, 10% CDN bonds, 10% GLobal bonds, 20% US bonds. 

 

2017 was a a good example of this discomfort. Take a balanced portfolio of a 60% Equity 40% Fixed income mix -The return of this reasonable portfolio in 2017? 8.319%. That’s right, just 8.319%. Plenty of asset classes performed poorly in 2017. The rub is that the S&P 500, by far the most popular proxy for “the market” returned more than 13%. Though that gap of about 7% is small compared to some of the big gaps shown above, many investors still seem to have a sense of frustration over their portfolios.

 

There is the phenomenon of “if only.” The science of regret is complex, but a key takeaway is that how we initially benchmark success will be a key determinant of happiness. In our portfolios, if we measure our success (by calendar year, no less) by comparing all of our investments to the top performer at that time, then we’re doomed to be displeased. It is in fact natural to feel recently that “if only a lot more of my assets were investing in a S&P 500 index fund….” But that mindset of chasing recent performance is a sure ticket to not meeting one’s long-term financial objectives. Woulda shoulda coulda is not a strategy worth pursuing.

 

Ultimately, the math of diversification makes sense. It’s the psychology of diversification that is muddled. The path forward is not to rethink the former, but to accept and think through the latter. It is not a smart alternative to concentrate one’s portfolio in what one predicts will be the hot dot. At the same, it’s also unfair to ourselves to ignore that diversification is often a bitter pill to swallow — even when it’s good for us.