Diversification? Why?

behaviorIt is early March 2014 as I write this blog. 2013, in hindsight, was a no-brainer year – just stay invested in the U.S. right? Well, this view suffers from at least two behavior flaws: 1) the influence of recent events and 2) hindsight bias.

By the time this is scheduled to post at the end of August 2014 (5 months or so), I suspect most will have forgotten how markets seemed to go sideways between Dow 16,530 and 15,370. Now in August, what do you remember about January and February? And 2013 news events are completely forgotten while most only remember the Dow having a good year (and seeing that in your 401k, IRA, etc statements). How wise we are to be invested in things that “always” go up. They don’t always go up. And that’s the reason for diversification.

This great article by Bob Seawright The Perfectly Dangerous Thing Your Clients Want does a great job explaining a number of misperceptions and reality.

“The key to “beating the market” in 2013 was thus simple if incredibly dangerous: no bonds, no shorts, no hedges, no diversification and no tactics. But because of my commitment to diversification, I would never advocate that sort of approach. Thus it’s a given that any portfolio I constructed would underperform U.S. stocks in 2013.” In fact, a diversified portfolio will rarely outperform some elements in it, nor will it underperform other elements in the portfolio. This is far different than saying it will always go up in value – what most people interpret the purpose of diversification to be.

“Clients tend to assume that we should be able to forecast markets like 2013 in advance. Oh that it were so.”

“The survey reads like a primer on recency bias in that bear markets lead to bearish market forecasts and vice versa with no predictive power whatsoever.” “A 2005 Dresdner Kleinwort study of market analysts showed the same thing, entirely consistent with a long line of academic research (most prominently from Philip Tetlock) establishing the lack of value provided by so-called “expert” forecasters across fields and disciplines.” (my emphasis). In other words, no one knows the future (and I’ve blogged on prediction before).

But, everyone assumes tomorrow will look like today, which looked like yesterday – and follow that recent trend into the future. Yet, we all know, trends suddenly change. When trends change, we know then why. But, knowing today why a trend would change in the future is not knowable today. We can guess. But guessing as a foundation for investing seems a poor strategy.

So, when people get their statements, they look at two things, what went up, and what didn’t. “However, for whatever reason, we humans tend to pick apart the pieces more than appreciate the whole. This problem relates to “fundamental attribution error”—the error we make when we overweight the role of the individual and underweight the roles of chance and context when trying to explain successes and failures.” Remember, Madoff promised only returns – no losses. That is not how markets work.

Expect some holdings to go up, and others to go down, sometimes together, sometimes not together. Each holding is not getting you to your goal alone. The combination of your holdings gets you to your goal. The combination of your holdings is called a portfolio. Concentrate on what the overall results are – and not so much on each ingredient. And remember, you are not investing for investing sake – you are investing for a reason (retirement, education, etc.).

Don’t get the means confused with the end. Focus on the end – also known as “your purpose for the money.” If you do this right, it shouldn’t go to zero value – it simply goes up and down in value based on the characteristics of the overall mix. As I often say – you don’t want to beat the markets; you simply want to be the market. This is done simply by prudently combining different indexes together – a.k.a., diversification.

 

 

About Larry Frank, Sr.

Larry R Frank Sr., MBA, CFP®, is an experienced financial advisor and a published author on Retirement Planning Research. Have a financial question? Click Here to Ask Larry

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