The influence of Pliny the Elder upon investors is not much discussed. But it should be, because it is dangerous.
that looks like a part of the body can be used to treat that part. So, for example, the toothwort – so called because its flowers look like teeth – can be used to cure toothache.
Most scientists now think this idea is pseudoscientific quackery. But people still act as though it is true outside of medicine. The psychologist Thomas Gilovich calls it the idea that like goes with like. Others call it the representativeness heuristic.
For example, imagine you had to place five consecutive bets on whether I would draw a red or white ball from a bag containing 60 red and 40 white balls. The best bet would be five reds. Experiments by Ariel Rubinstein at Tel Aviv University, however, have shown that when faced with such bets, people don’t do this. Instead, they make their bets look like what they are betting on – such as three bets on red and two on white. This is a version of the doctrine of signatures.
Many investors act as though they apply this doctrine. They believe that because the world is a complex place, so too must be their portfolios. The cure for complexity in the world, they implicitly think, is complexity in their portfolios.
This is wrong. For one thing, complex portfolios can be fragile – as we saw with the collapse of Long-Term Capital Management in 1998 and with banks who’d invested heavily in collateralised debt obligations a decade later. Granted, retail investors aren’t exposed to such great danger because most of us are not so highly leveraged. But these episodes point to a problem that does afflict us – that complex portfolios can contain assets that are hard to sell in bad times, such as property and property funds.
And for another thing, the same complexity that makes the world unpredictable means we cannot spot the best funds, stocks and strategies. This warns us not to be too clever.
Instead, the solution to complexity is the exact opposite of that recommended by the doctrine of signatures. We should have simple portfolios. Here, we should be guided by four basic principles.
First, back the field. In a complex world, picking winning stocks is hard, not least because, as Arizona State University’s Hendrik Bessembinder has shown, most stock market returns in the long run come from only around 1 per cent of shares. Miss out on these, and you underperform the market. If we can’t pick winners, though, we can back all the horses. A global tracker fund does just this. It is a fund of all equity funds – and a low-cost one at that. You might add to this an emerging market fund to capture the risk that developed markets might under-perform poorer ones. And you might add a private equity fund because a stock market listing might not be the corporate form that best promotes growth. But a tracker should be your core holding.
Secondly, hold some non-equity assets, be they bonds, cash or gilts. This year has reminded us of a longstanding fact – that when equities fall a lot, they do so all together around the world. You cannot diversify short-term equity risk by spreading your equity holdings. You need other assets. Not that this need be complicated. A simple portfolio of five assets – world equities, gilts, gold and sterling and US dollar cash has given a total return so far this year of 6 per cent, while the All-Share index is down 18 per cent.
Thirdly, cash really is king. It protects us from some nasty risks. One is that diversification might not continue to pay off so well because assets can fall at the same time. This would happen if investors were to fear tighter monetary policy. A second is that some assets can be hard to sell in bad times, such as property or private equity. Cash saves us from the horrible fate of being a forced seller.
Finally, don’t try to optimise. Just make do with a portfolio you are comfortable with. To use the word coined by the Nobel laureate Herbert Simon, we must satisfice. Optimisation is something used to test economics students – their patience as much as their ability. It’s of limited use in the real complex world. And it can be downright dangerous. Banks’ portfolios of mortgage derivatives were optimised in 2007 – but upon a set of assumptions that ceased to be true.
All this sounds boring. Which is the point. Of course, there are countless interesting stories we can tell about how to position our portfolios for how the complex emergent system that is the economy will evolve. But nice stories can mislead us. The story that cures resemble the disease is a nice one – but that doesn’t make it true or useful.
