16 Jun Who Knows? Nobody Knows…so diversify!
Risk management is a familiar term to clients who probably hear it at every meeting with their investment advisor in what is likely to be the most boring part of the conversation. Since it is not-so-exciting, it may not be given enough time. Being boring does not mean unimportant – in fact, in this case it is quite the opposite. There is arguably no part of any meeting which is more important. A fundamental aspect of risk management is described by another well-known word – diversification, most easily described by the wise saying “Don’t put all your eggs in one basket”. The concept is common sense and does not only apply to investors but to many facets of life. This article will focus on diversification and why it is so fundamental to investing.
Diversification is necessary because we are limited in our ability to make decisions given that we know nothing about the future. The potential outcome of a decision is rarely binary, rather there are multiple and perhaps infinite possibilities. This comment is as relevant to how we invest our money as it is to a variety of other subjects. When a decision needs to be made, people consider the information they have on hand, information which is entirely based on the past. We can certainly have ideas about the future, but they are all a combination of knowledge of past events and assumptions. Enter another saying, “To assume makes an ass out of U and Me”. The intent of this comedic quote is not to say that assumptions are bad but rather to never forget that they are not truth and treating them as fact is reckless and has consequences.
A logical approach to decision-making would be to gather as much data as possible and assess as many outcomes as possible, assigning each with a probability of occurrence. Unfortunately, in addition to the issues related to assumptions, there are many obstacles to achieving a comfortable degree of certainty. Some common challenges include:
- Increased data may risk overconfidence.
- Methods of data collection and interpretation are highly variable.
- The quest for data could lead to inaction.
- Bias to look for data supportive of views.
- Bias to fail to incorporate new data into views.
- Bias to put too much faith in an outcome.
- Minimization of the frequency of extreme events (natural disasters, financial crises, disease).
- We don’t know what we don’t know.
I have a background in science and am often baffled by the amount of time and resources people dedicate to predicting financial markets and economics. Neither are natural sciences. They are social sciences which are based on human behaviour which is inherently unpredictable. In natural sciences, there is a higher degree of certainty once we have discovered basic laws. Physics tells me that I can be 100% confident that if I let go of a ball, it will drop to the ground. Chemistry can describe in advance what will happen by mixing two chemicals. However, in the latter case, some uncertainty remains since laboratory techniques involve several steps each prone to human error. Even within the realm of the natural sciences, our knowledge is still limited, but the more we learn, the more visibility we have as to outcomes. This is not the case for the social sciences where it is unlikely that decisions will ever carry reasonable certainty. Even if you manage to have the best data which you have assessed as perfectly as possible from the most objective viewpoint, you will never predict that a virus is going to come along and freeze global economic activity. You will never predict when an oil spill will occur. You will never predict a sudden geopolitical shift.
Does this mean that for the social sciences we shouldn’t think about the future? Of course not. It simply underscores that we need to be humble and make decisions while fully aware of the limitations. Being a humble investor means diversifying your portfolio. Diversification occurs across many levels such as asset allocation, geography, revenue streams, methodology, sector, industry, individual securities/managers, currencies. I have previously written about how Blue Bridge diversifies its portfolios. The recent upheaval of financial markets demonstrated the importance of this approach when we saw assets traditionally considered as low risk thrown to the mercy of markets and suffering far more than most investors assumed.
One might ask if decision-making processes should change in a period such as the one in which we are currently living. Not necessarily since this period is the environment typically used to frame risk decisions. It is easy to look back in hindsight and feel that in the decade prior to 2020, decisions were being made in a stable context but when we were living in that context, it didn’t feel stable. This is exactly the case for financial markets. The 2008 financial crisis remained fresh in our minds for a long time. Policy makers in many countries had to frequently respond to ease financial conditions. We saw countries approaching debt default deadlines (i.e. Greece) and debt ceilings (US). We saw the election of populist leaders. I could go on and on and on. These events defined a period which did not feel stable at all. Now people are faced with an accelerated transition of major themes which were already at play – deglobalization, technological advances, geopolitical relationships, demographic challenges, climate change, etc. How these elements play out is certainly uncertain, but what else is new?
In the financial world, it is typical to hear that something is currently causing a high degree of uncertainty. I would argue that there is always a high degree of uncertainty because the outcome of anything is always uncertain, which means that you should diversify your investments…unless of course you have a time machine or the more cliché “crystal ball”.