Most investors understand the benefits of having of a diversified portfolio. Even before the advantages of diversification were formally codified and quantified through the development of Modern Portfolio Theory in the 1950’s, most people were already familiar with the advice to “not put all your eggs in one basket.” This recommendation stems from a quote in “Don Quixote”, which was written by Miguel de Cervantes in 1605, so it’s fair to say that diversification, as a means to reduce risk, has been around for a long time.
Unfortunately, while the logic and theory supporting diversification is well understood, investors occasionally have a tough time dealing with it in practice. In a well-diversified portfolio, the components will not all move in lockstep; some will be performing well at the same time that others are not. (After all, if this were not the case – if, for instance, all portfolio assets were moving in a similar direction – that would indicate a lack of diversification).
The problem begins when investors open their account statement and, rather than reviewing their portfolios as a whole, examine their holdings on a line-by-line basis. Investors will often focus on portfolio assets that haven’t performed well. This is due to what is termed ‘loss aversion’ in behavioral finance. Psychologically, the negative feelings we experience due to losses are more powerful than the positive feelings we experience from gains. For this reason, an investor’s eye will often be drawn to portfolio holdings that are in the red. Even though the portfolio as a whole may be performing well and in-line with the investor’s goals, the emotional impact of seeing a loss in a particular holding is jarring.
So, when this happens, how should an investor handle these feelings?
The first step is to recognize that loss aversion results from understandable evolutionary roots. For an animal that is living in an unhospitable environment, the loss of a small amount of food could mean death; that same animal doesn’t benefit equivalently by getting a couple extra days of food (especially since he or she probably doesn’t have a refrigerator). This animal will certainly feel a loss more acutely than a gain. As feelings like this lead organisms to act in ways that helped them survive, it is not surprising that humans developed to internalize loss aversion emotionally. In the present day though, investors need to recognize this response for the evolutionary vestige that it is, and cultivate the ability to examine their financial matters in an objective and empirical manner.
To further this aim, investors should consider what parts of their portfolio increased in value as a result of the same forces that caused the decrease in other holdings. For instance, to take a present day example, if a small cap value holding hasn’t performed well this year, investors should keep in mind that the same macro factors responsible for this underperformance are also responsible for the outperformance of their international large cap stocks. Both outcomes stem from the same underlying conditions. Understanding that the gain in one wouldn’t have been possible without the loss in the other may help to reinforce that portfolio assets are meant to ‘work together’.
Additionally, investors should try to take a long-term view toward portfolio evaluations. A properly constructed portfolio is meant to work over the long-term - through different market conditions and stages of the business cycle. For this reason, a scheduled and complete portfolio assessment is the right time to consider whether the portfolio is positioned properly and to evaluate performance from a multi-faceted risk and reward perspective. Hitting the ‘refresh’ button on an investment website isn’t a helpful substitute or supplement for a systematic and comprehensive examination of portfolio performance and may work counter to an investor’s long-term goals by reinforcing shorter-term performance evaluation and providing opportunities for loss averse behavioral errors.
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Diversification does not guarantee a profit nor protect against loss in a declining market. It is method used to help manage risk.