Often when the world is in turmoil, old rules and long-held “truths” go out the window. This is precisely what we are seeing today with several established theories on investing, including the broad diversification espoused in “modern” portfolio theory.
The theory behind diversification as been applied according to a [poor] interpretation that it allows investors to build a portfolio that they can simply leave alone for extended periods of time. In a world where many people stress over finances, this theory allowed investors to feel comfortable with the “safety” of their assets so they could sleep at night and go about their lives.
The problems with this approach are numerous, the simplest being conceptual: when building a portfolio, investors and advisors are trying to answer questions about how circumstances will play out. The problem as this applies to diversification is that the questions to be answered are constantly changing, and how investors’ answers must follow suit.
The only way to “win” in the investment world is by preparing for the next battle, NOT by fighting the last one. Investors who use broad diversify are essentially preparing for the next battle by studying many of those previously waged, rather than anticipating what is to come.
Granted, this would not be an altogether terrible theory if it were applied correctly; but doing so is nearly impossible.
First and foremost, many of the assumptions considered in diversification techniques are faulty; the odds of various events or the development of given circumstances simply aren’t correct.
Consider, as an example, the odds of Japan being struck by a 9.0 earthquake, followed by a tsunami more than thirty feet tall in some places, which in turn wiped out the generators cooling a nuclear power plant at Fukushima, causing a meltdown.
These events were obviously not anything that could be easily predicted. However, according to the models used in modern theories of diversification, this confluence of factors should never have happened. The odds are simply too small and the world to young for these events ever to have taken place; if you believe the statistics.
In other words, hundred year floods seem to happen far more often.
In addition to poor modeling, modern portfolio theory operates according to many bad rules. In an attempt to establish reliable principles that operate independent from circumstances, many have oversimplified and made rules too general or too narrow.
In some cases, an investor – or worse yet, an advisor – simply lacks the investment memory to make decisions with the right perspective. One rule that comes to mind is the relative weight of bonds and equities in an investor’s portfolio.
This rule (subtract the investors age from 100 and that is the percent that should be in stocks) is far too broad. According to this rule, a good deal of 80-year olds today have more than three-quarters of their portfolio in bonds. How many of them remember what happens to bonds during prolonged times of rising interest rates? How many realize that interest rates today are the lowest they’ve been in almost forty years, and that the odds that they will increase in the long-term are a near-certainty?
Perhaps the best example of a short investment memory in today’s market is gold’s recent popularity. Over the past 12 years the price of gold has risen by almost six times. However, most people buying gold today don’t remember a time when gold wasn’t going up. How many people remember than in the 20 years before this recent bull market in gold began, the price of bullion had fallen more than 70% from its previous high in 1980?
The investment world is a scary place. The markets are a beast that must constantly be studied and interpreted. While buy-and-hold theories of broad-based diversification may relieve a lot of the stress of forecasting and anticipating how event will develop, they certainly are not without their shortfalls.
