The Myth of Diversification And The Risk of Psychological Leverage
The comments below are an edited and abridged synopsis of an article David Robertson
Every once in a while, it can be helpful to take a step back from busy daily routines to revisit assumptions and beliefs, and to experience things anew.
The same case can be made for revisiting investment principles, and this is exactly what 3 different pieces of recent research do. Some insights are new. Some are useful reminders. All are relevant for investors who are navigating difficult markets.
Robertson presents two papers by Edward F. McQuarrie, Professor Emeritus at Santa Clara University (links provided), who expands the range of holding period returns for bonds to the 1793-1857 period. With this, he expands the historical perspective of asset returns and opens the door to a fresh interpretation of it.
In short, investors should do what professional investors do not do: Accept that there is uncertainty in returns, and moderate views in a way that is commensurate with the level of uncertainty.
Reviewing this research reveals that much of what passes for conventional investment advice needs to be updated. Stocks are not the best decision for retirement plans. Diversification often fails, which requires more active and dynamic risk management. It is hard to separate skill from luck, and decisions should reflect that uncertainty. As such, there are certitudes to discard, expectations to reset, and portfolios to re-build.
Stepping back also shines a light on the investment industry itself.
Perhaps the business risk and career risk of many investment professionals has become so enmeshed with psychological leverage that they are not capable of taking a step back and re-evaluating what is best for their clients. If this is true, a similar set of changes could also be in store for the investment services industry—with certitudes to discard, expectations to reset, and businesses to re-build.