Our expectations shape our actions as humans, and investing is no different. The problem with investing, however, is that we can have misplaced expectations without realizing it. They creep in subtly and can wreck your portfolio before you have the chance to change.
Basic Expectations with Diversification
Take diversification, for example, and see how expectations plays a role: Harry Markowitz won the Nobel prize in economics in 1990 for an idea called “Modern Portfolio Theory.” He answered the question, “How do you put a portfolio together to maximize expected return for a given level of risk?”
Ok, that’s a mouthful, but it means that we want the most return possible with the least risk.
We have to say “expected return,” though, because we can’t predict the future nor can we know exactly what the returns will be. We can, however, use historical data to get a good estimate of what they will be.
The other part is that we can choose different amounts of risk based on several factors, tailored to an individual. For example, someone with 30 years before retirement can put up with a lot more risk than someone two years out. So, their portfolios are structured differently, one with more risk, and the other with less. Learn more about risk here.
The important thing is you don’t want to have a risky portfolio with a low expected return. You’re taking on more risk than is necessary, and this is what Modern Portfolio Theory is all about—taking the least risk, for the most expected return.
One of the keys is putting different types of investments together that don’t move with each other all the time. One zigs, while the other one zags; sometimes they move together, but they are different enough to get rid of some of the volatility.
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Where Expectations Come In
One of the most common mistakes investors make is thinking that a diversified portfolio will always beat an undiversified portfolio. The current example is with large US stocks. Over the last few years, a large US stock portfolio has outperformed a diversified portfolio.
I’ve seen this mistake repeatedly.
When I first got into business, it was international stocks, then it was tech stocks—there’s always some recent, hot investment that is beating a diversified portfolio.
Because of that, investors go, Wait a minute, I thought a diversified portfolio was always the best. diversification must be broken! They had a misled expectation, and it caused them to come to a false conclusion: diversification is broken.
From this false conclusion, they may make a huge mistake and sell their diversified portfolio for one made up of all large US stocks (or whatever the current trend may be).
Should a Diversified Portfolio Always Be the Top-Performer?
Simple answer: A diversified portfolio should almost never be the highest performing investment out there.
If you’re unfamiliar with the idea, that sounds counterintuitive at first.
So if it goes against intuition, then why diversify?
Because we don’t know which investment will be the top performer going forward. It’s easy to look in the past and see what hasbeen the best, but it’s impossible to look in the future and see what willdo the best.
If we’re always buying the best performers of the past and selling the worst performers of the present, we’re constantly buying high and selling low. This is a dangerous cycle that has killed investment returns time and time again.
A diversified portfolio protects us from this costly mistake. If we own all the relevant investment categories, we almost always have a part of our portfolio that is doing well.
Sure, there will be some areas that are not doing as well, and this will make the overall portfolio underperform one made up solely of the top performer.
Over the long-run a diversified portfolio has a higher expected return—with less risk—than a portfolio of chasing yesterday’s winners.
In order to make it work, though, we must have the right expectations from the outset.
Diversification and Football
Think about this with a hypothetical example from football: Let’s say we have a football team that hasn’t been winning (Tennessee fans don’t have to stretch their minds too far for this one, unfortunately).
Because they haven’t been winning, they fire the coach and hire a new one.
He may be one of the best coaches out there, but let’s say he comes in and doesn’t win the first few games. If the people who run the team have no patience, they might get mad and fire him.
But then what happens?
They do even worse.
Then, this hypothetical football team hires a new coach, but he doesn’t immediately win either, so our team owner with zero patience fires him too. It’s a revolving door of coaches, and it’s a never-ending cycle of losing.
Building a winning football program takes patience.
Diversification also requires patience and proper expectations.
A diversified portfolio in the long-run has a higher expected return with lower volatility, but it won’t always be the top performing investment out there.
We’d be happy to coach you about diversification and more. Schedule a call with us today by clicking here.
Written by Paul Winkler
*Advisory services offered through Paul Winkler, Inc. (‘PWI’), a Registered Investment Advisor. PWI does not provide tax or legal advice: Please consult your tax or legal advisor regarding your particular situation. This information is provided for informational purposes only and should not be construed to be a solicitation for the purchase or sale of any securities. Information we provide on our website, and in our publications and social media, does not constitute a solicitation or offer to sell securities or investment advisory services, or a solicitation to buy or an offer to sell a security to any person in any jurisdiction where such offer, solicitation, purchase, or sale would be unlawful under the securities laws of such jurisdiction.