Diversification, or the reduction of non-market risk by investing in a variety of assets, is one of the hallmarks of traditional approaches to investing. What is less appreciated, however, are the ways in which it makes emotional as well as economic sense not to have all of your eggs in one basket. As is so often the case, the poets, philosophers and aesthetes beat the mathematicians to understanding this basic tenet of emotional self-regulation. The Bible mentions the benefits of diversification as a risk management technique in Ecclesiastes, a book estimated to have been written roughly 935 BC. It reads:
“But divide your investments among many places,
for you do not know what risks might lie ahead.”
- Ecclesiastes 11:2
The Talmud too references an early form of diversification, the prescription there being too split one’s assets into three parts – one third in business, another third in currency and the final third in real estate.
The most famous, and perhaps most eloquent, early mention of diversification is found in Shakespeare’s, “The Merchant of Venice”, where we read:
“My ventures are not in one bottom trusted,
Nor to one place, nor is my whole estate
Upon the fortune of this present year:
Therefore, my merchandise makes me not sad.”
It is interesting to note how these early mentions of diversification focus as much on human psychology as they do the economic benefits of diversification, for investing broadly is as much about managing fear and uncertainty as it is making money.
Brought to the forefront by Harry Markowitz in the 1950’s, diversification across a number of asset classes reduced volatility and the impact of what is known as “variance drain.” Variance drain sounds heady, but in a nutshell, it refers to the detrimental effects of compounding wealth off of low lows when investing in a highly volatile manner. Even when arithmetic means are the same, the impact on accumulated wealth can be dramatic.
Say you invest $100,000 each in two products that both average ten percent returns per year, one with great volatility and the other with managed volatility. The managed volatility money rises 10% for each of two years, yielding a final result of $121,000. The more volatile investment returns -20% in year one and a whopping 40% in year two, also resulting in a similar 10% average yearly gain. The good news is that you can brag to your golf buddies about having achieved a 40% return – you are an investment wizard! The bad news, however, is that your investment will sit at a mere $112,000, fully $9,000 less than your investment in the less volatile investment since your gains compounded off of lower lows.
Managing variance drain is important, but a second, more important benefit of diversification is that it constrains bad behavior. As we’ve said on many occasions, the average equity investor lags the returns of the equity market significantly. It is simply hard to overstate the wealth destroying impact of volatility-borne irrationality. The behavioral implication of volatile holdings is that the ride is harder to bear for loss-averse investors (yes, that means you).
As volatility increases, so too does the chance of a paper loss which is likely to decrease holding periods and increase trading behavior, both of which are correlated with decreased returns. Warren Buffett’s first rule of investing is to never lose money. His second rule? Never forget the first rule. The Oracle of Omaha understands both the financial and behavioral ruin that come from taking oversized risk, and more importantly, the power of winning by not losing.
With bad news seemingly everywhere and situated at the end of a long-in-the-tooth bull market it’s not hard to see why investors are rattled. But at times like this, it behooves investors to take a deep breath and rely on rules instead of emotions. To assist you in this difficult time, I’ve prepared a handful of “do’s” for worried investors, with the “don’ts” to follow in my next post.
Do Know Your History – Despite what political pundits and TV commentators would have you believe, this is not an unusually scary time to be alive. Although you’d never know it from watching cable, the economy is growing (slowly) and most quality of life statistics (e.g., crime, drug use, teen pregnancy) have been headed in the right direction for years! Markets always have and always will climb a wall of worry, rewarding those who stay the course and punishing those who succumb to fear.
Warren Buffett expressed this beautifully when he said, “In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” Such it has ever been, thus will it ever be.
Do Take Responsibility – Pop quiz! Which of the following do you think is most predictive of financial performance – a. market timing b. investment returns c. financial behavior? Ask most any man or woman on the street and they are likely to tell you that timing and returns are the biggest drivers of financial performance, but the research tells another story. In fact, the research says that you – that’s right – you, are the best friend and the worst enemy of your own portfolio.
Over the last 20 years, the market has returned roughly 8.25% per annum, but the average retail investor has kept just over 4% of those gains because of poor investment behavior. What happens in world financial markets in the coming years is absolutely out of your control. But your ability to follow a plan, diversify across asset classes and maintain your composure are squarely within your power. At times when market moves can feel haphazard, it helps to remember who is really in charge.
Do Work with a Professional – Odds are that when you chose your financial advisor, you selected her because of her academic pedigree, years of experience or a sound investment philosophy. Ironically, what you likely overlooked entirely is the largest value she adds – managing your behavior. Studies from sources as diverse as Aon Hewitt, Vanguard and Morningstar put the value added from working with an advisor at 2 to 3% per year. Compound that effect over a lifetime and the power of financial advice quickly becomes evident.
Vanguard suggests that the benefit of working with an advisor is “lumpy”, that is, the effects of working with an advisor are most pronounced during periods of volatility (like today). They go so far as to break out the impact of the various services provided by an advisor, and while asset management accounts for less than half of one percent, behavioral coaching accounts for fully half of the value provided by working with a professional. Today is the day your financial advisor earns her keep. Don’t be afraid to reach out to your advisor during times of fear and seek her reassurance and advice. After all, she’s saving you more money by holding your hand than by managing your money!
Ancient Grecians believed in geocentricity, the idea that the Earth is the center of the Universe around which all others objects orbit. In classical antiquity, it was widely supposed that the body contained four humors, blood, black bile, yellow bile and phlegm, and that optimal health resulted from an appropriate balance of the four. Maternal Impressionists explained birth defects in children as resulting from negative thoughts from the mother during pregnancy. And phrenology, the practice of making inferences about someone’s character and personality from the shape and contour of their head, was for some time thought to be a legitimate science.
Much as we laugh at these pseudo-scientific anachronisms, I am confident that the time is not far distant that we will puzzle that we ever developed financial models that did not somehow seek to account for the behavior of market participants. In making such a provocative statement, I do not wish to pick on traditional financial models or necessarily to elevate what currently constitutes the burgeoning field of behavioral finance. Rather, I hope to illuminate the ways in which arriving at any sort of truth is an imperfect endeavor and discuss the way in which ideas that begin on the lunatic fringe can sometimes be welcomed into the fold of legitimate scientific inquiry.
Almost since its inception and increasingly with its popularization, proponents of behavioral finance have delighted in dismantling the efficient market machine, gleefully poking holes in this dogma with quirky anecdotes about investor irrationality. For their part, efficient market theorists have given as good as they’ve gotten, criticizing behavioral finance for its lack of theoretical underpinning and inability to consistently improve investment returns. But all of this rhetorical jousting (while fun!), misses the point fundamentally.
Rather than hoping for the death or preeminence of one faction or the other, we ought to be working to combine the findings of both camps in applied ways that positively impacts actual investors, something Dr. Greg Davies calls “behavioralizing finance.” Behavioral finance has a great deal to learn from efficient market theorists about building a comprehensive, rigorous framework of assumptions. Traditional finance could learn a thing or two from the behaviorists about being tentative, respecting the limits of knowledge and safeguarding others’ assets accordingly.
Behavioral finance was born in the ivory tower of academia, legitimized with Daniel Kahneman’s Nobel Prize, popularized by Dan Ariely, Richard Thaler and others who taught us to laugh at and recognize our own financial misbehavior. Oddly enough, the next step in the progression of behavioral finance is an anonymity of sorts, the kind that comes with widespread acceptance and integration. After all, heliocentrism is not an idea anymore, it’s the “way things are.”
My children are six and two and it is my hope that when they attend college there will be no behavioral finance courses offered at their universities. If there are, we will still be mired in the same intellectual turf wars that can keep great ideas from exploring their points of fusion rather than their surface dissimilarities. My hope instead is that they will learn about finance, a complicated, tentative, somewhat messy discipline that their professors approach with some mathematical precision, but would never dream of disconnecting from the people that give it life.