Decision-Making and Diversification
"No matter how great the talent or efforts, some things take time. You can't produce a baby in one month by getting nine women pregnant." — Warren Buffett
Welcome to my blog and thank you for checking it out! My vision is to periodically share ideas that our investment committee has been discussing. No set schedule—I’ll wait until there’s something timely.
I wanted to set the stage with thinking about how we approach stock market events and in a larger sense, our lives. It starts with focusing on what we can control (our decisions and temperament) and what we can’t control (most everything else).
Follow the Serenity Prayer, “Grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference.”
Knowing the difference between what you can and can’t control is important in how you measure results. When you boil down why an event turned out the way it did, it is typically not productive to waste time and energy focusing on things outside of your control. We can’t control whether the market went up or down, if interest rates rose or fell, or which way our home’s value went. In investing, what we can control and manage is the quality of our decisions. How do we make decisions? Is our decision making process objective or based on our emotions? Are there behavioral biases that may be skewing our view? Is there historical evidence that supports our decisions?
Investing involves MANY decisions. How much risk should I take? In which assets should I invest? How should I diversify to reduce risk? Which managers should I use?
One thing we do know is that nothing works all of the time. In the short run, even the best decisions can look unwise.
For example, hypothetically, we might take on a new client and invest their portfolio only to have a particular asset class drop substantially shortly afterward. Was that investment decision a mistake? Probably not. Is the timeframe we are looking at much too short? Probably yes.
From 1950 to the present, the U.S. stock market has gone up 53.7% of days, 56.9% of weeks, and 60.2% of months. Looking at larger intervals, it’s gone up 78.8% of years, 92.2% of each five year period and 96.6% of each ten year period.1 Viewed on a day-to-day basis, those odds aren’t much better than a coin flip, but over longer periods of time, the odds get stronger. That being said, there is still a chance for a negative return, even over long stretches of time.
All of this relates to the question of diversification. Right now, much of the coverage by the media is about U.S stocks reaching new all-time highs, led mainly by the tech sector. However, the media seems to be missing the fact that year-to-date, many other asset classes have been treading water or have been negative. Taking it a step further, most asset classes, relative to US equities over the last five years, have had a negative effect on overall portfolio performance.
In light of these recent circumstances, it is natural to wonder, “Should I just buy an S&P 500 index fund and be done with it?” Does diversification actually help?
In our quarterly newsletters, we have been running a series on common “behavioral” biases. One of the most challenging is called “recency bias,” when people tend to gravitate towards what has worked in the recent past. Another bias is the “hot hand fallacy” when people believe that random success will be repeated. In the last several years, U.S. equities have done well and have been favored investments to own. Our minds can trick us into overestimating the odds that this successful trend will continue. Because markets are naturally volatile and unpredictable, this type of thinking could potentially lead to buying high and selling low if investors chase whatever has done well recently.
To illustrate the risk of owning a single asset class like U.S. stocks, let’s go back for a moment to 2009. If you had all of your money in the S&P 500 for the previous ten years (2000-2009)—also known as the “lost decade”—you would have averaged a -1 % return per year for 10 years!2 You would have also needed to stomach two historical market declines without throwing in the towel on your investment strategy.
Over that same decade, broad diversification by asset class worked very well. Many of the same asset classes that are out of favor today such as emerging markets, commodities, bonds, etc., did perform well during that time period. In addition, since a diversified portfolio generally will not drop to the extent that the U.S. equity market did, you may have had a much better chance of sticking to your plan and staying invested rather than reacting to natural emotions and biases.
Harry Markowitz has famously said that the only free lunch in investing is diversification—and we agree. We know we are not smart enough to predict which asset class will do the best next week or next year, nor do we think anyone else can on a consistent basis. What we do know is that diversification gives you stronger odds to achieve your financial goals over the long run.
Some things just take time. Stay patient, my friends!
1 Dimensional Fund Advisors, Returns 2.0. S&P 500 data from 1/3/1950-9/25/2018
2 Dimensional Fund Advisors, Matrix Book 2018
The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.