Recall the year 1999. It may seem eons ago, but just a mere over 20’ish years (to those too young to have experienced the markets, this is your history lesson). This was the glory days of the tech bubble. These dotcom companies, unable to produce any profit in the foreseeable future, were the asset class that most investors plowed almost all their portfolio into. And why not, the previous year’s returns were “off the charts” good. The average investor, driven by their own Recency Bias, believed it would go on – forever. As a result, their once diversified portfolio was now narrowed to one idea/sector.
To visualize what the average investors were doing - narrowing of the portfolio to one idea/sector – imagine this: each morning, as the markets opened, the investor was placing a bullet inside a gun, spinning the chamber, and pointing it at their portfolio’s “financial head” to then pull the trigger. Until one day – it went off and the NASDAQ crashed some 80% from peak-to-trough1. To further foreshadow the event, the average investor was disappointed (and in some cases looking to remove their financial advisor) due to receiving a measly 14% return in a properly diversified portfolio. The final sign was the chatter in the news of how Warren Buffett (after underperforming the index for some years) had lost his investment edge and what he “used to do” was no longer the way to invest.
Fast forward to today. The markets have just come off two successful years of performance – driven primarily by one sector – large technology stocks. More to the point, around six companies that have driven just about all the returns of the S&P 500 index returns2. Is this a fair comparison from the dotcom bubble era – not entirely due to these companies at least have earnings, but the behavior is now becoming the same. The gun is now being loaded – once again.
How can the average investor save themselves…from themselves? In a word – Diversification. As Nick Murray has stated, “diversification simply means that I’ll never own enough of any one sector/idea to make a killing in it, nor enough to get killed by it.” What, you may ask, is a diversified equity portfolio? A diversified equity portfolio owns multiple areas within each asset class: meaning Large/Medium/Small companies both domestic and globally. Understanding this, you still (at least your emotional brain) may be asking – Why? Because nobody knows what sectors are going to be outperforming each calendar year – Nobody. It is unknowable.
To demonstrate just how difficult it is to pick next years winner, we refer to the Period Table of Asset Class Returns provided by Ben Carlson’s A Wealth of Common Sense blog from year end 2020. The best performing asset class is at the top and the worst at the bottom.
What it depicts (and proves my point) is the utter randomness and unknowability to prognosticate next year’s winner – hence my topic of diversification. The asset class of EW (equal-weight) is an example of what a diversified portfolio would look (and act) like in all economic environments, if your financial planner recommended all the above asset classes.
And if you diversify properly – the proof will be that you will always have something in your portfolio you don’t like. Voila, you are now diversified and have saved yourself from…your emotional self.
If you still believe you can successfully choose next year’s winner, let us examine the Unknowable’s:
The next 15% move in the market up or down, interest rates, the value of the dollar, bonds vs. stocks, growth vs. value, large companies vs. small, if unemployment will peak or fall in the next 12 months, if inflation will increase this year, and if government spending will…oh yeah, we do know that one (sorry – couldn’t resist).
Finally, you may be asking – how can an investor take advantage of this randomness of the asset class returns unknowability? First, recognize you don’t know – what you don’t know. Nor does anyone else for that matter. Meaning you can’t time when one sector will go from hot to cold and the prior year’s cold sector becomes hot. Secondly, although we don’t know - the next principle (soon to be written) does – it is called rebalancing.
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- Wikipedia dot com bubble
- David Lynch – Article: Rising stock market would be in the red without a handful of familiar names, August 20, 2020
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