Economics and investment: when in doubt, diversify

When you can't predict what's round the corner it's time to spread the risk
October 9, 2019

“It’s tough to make predictions, especially about the future,” is one of the many amusing quotes often, and perhaps incorrectly, attributed to 1950s baseball player Yogi Berra. It is, though, one that investment professionals and economists are likely to reach for when they are not sure what is going to happen next. Now is one of those times. 

It is not just Brexit causing uncertainty, but the Sino-American trade war, geopolitical tensions in the Middle East, uncertain politics in Europe and a global economy that looks to be slowing. The outlook is harder to call than at any point in recent years. In times such as these, it is best to stop quoting Berra and start reading Harry Markowitz. Markowitz won the Nobel Prize for his work on portfolio theory and had his own aphorism: “diversification is the only free lunch in finance.”

Diversification is important throughout the economic cycle, but doubly so when the road ahead is foggy. True diversification means a broad portfolio invested across asset classes, geographies and currencies. Most crucially, it requires investments that tend not to move in the same direction as each other. Everyone knows you should not put all your eggs in one basket, but putting your eggs in three baskets that are all prone to collapse at the same time is not much help either.

When constructing or reviewing a portfolio, people often fall into a few straightforward traps. Behavioural economics identifies several to watch out for. 

The first is home country bias. There is a tendency to overweight equities and bonds in one’s own country and this applies as much to professional fund managers as retail investors. Almost by definition, this lowers diversification and increases risk. People claim greater knowledge of their home market or fear higher transaction costs for overseas investments, but while that may have been justified a few decades ago, today there are plenty of low-cost ways to access foreign shares and bonds.

The second trap is anchoring. This is the approach that gives disproportionate weight to pre-existing information, typically learned when first examining an investment, which may no longer be relevant. Take UK government bonds. Anyone who started investing in the early 2000s might believe they should carry a yield of something like 5 per cent. They are “anchored” on that number. With yields currently below 1 per cent, some will see them as offering no value. But the world has changed since the 1990s—demographic and productivity trends have lowered interest rates. To fully reap the benefits of diversification, one needs to cast off mental anchors acquired in the past and look at the world economy as it actually is.

Finally, there is the “sunk cost fallacy.” Too many investors fixate on the price they paid for something, rather than what it is actually worth. They hold on to their losers for too long in the hope of getting their money back. But mistakes happen. It’s much better to cut your losses and move on.

When the global outlook is so unclear, investors face a choice: confidently predict the future and invest accordingly, or spread risk to cope with multiple future scenarios. The first approach offers potentially high returns but also higher risks. A true Nostradamus should act accordingly. For most people, though, it is times like these when the free lunch of diversification is most useful.

Now read Andy Davis on the Bank of England and the race to succeed Mark Carney