Many of you hold economists in low esteem, and reasonably so if you judge them on their forecasting record. But they do have some useful advice to offer – and one piece in particular is underappreciated.
This is the idea that what matters is your portfolio as a whole, more than any part of it. Everything you are investing for – whether to finance lavish spending, achieve a secure retirement, leave money to your children or whatever – depends upon your overall wealth. So it’s this that matters.
Obvious as it seems, this has some implications that are often forgotten. Here are four.
Background risks matter
Your whole portfolio includes all your sources of income such as your job or pension. And these should affect your investment choices. If you have a job where your income could fall a lot in recessions then equities (and especially cyclical ones) are especially risky: holding them means that you’ve got lots of eggs in the one basket of a healthy economy. If, on the other hand, you have retired on a final-salary pension then you are free from cyclical risk and so can take more of it in your equity investments. Which is handy, because such risk pays off well in good times.
Sounds trivial, doesn’t it? Maybe. But it blows apart the standard advice that we should hold fewer equities as we age. If you move from a risky job into retirement on a safe pension, you should actually do the exact opposite, and increase your equity exposure.
Don’t sweat the small stuff
Say you own 30 stocks, so each accounts on average for 3.3 per cent of your portfolio. A 50 per cent rise in one would then add only 1.6 per cent to your portfolio. Which is really only the difference between a good week and an average one for the market as a whole. And because there’s only a slim chance of a stock making such a gain, the expected value of it is even lower than this. Which is scant reward for the trouble of researching stocks.
This is why economists have traditionally said that asset allocation is more important than stock selection: getting the right mix of equities and safe assets makes more difference to your returns than getting a stock pick right.
Of course, many of you enjoy pitting your wits against the market and judge your successes and failures stock-by-stock. That’s fine if investing is a hobby. If what matters is your overall wealth, however, holding lots of stocks means each stock-pick makes little difference. That’s what diversification means: it dilutes good returns as well as losses.
Beware of doubling up
Just because a stock or fund looks attractive is no reason to buy it. Instead, because what matters is your portfolio as a whole, the question is: what does this asset add to my portfolio? And sometimes, the answer is: nothing, even for an attractive asset.
Say, for example, you are bullish about emerging markets and hold lots of them. Should you then hold mining stocks? It’s tempting. The same global economic upturn and increasing appetite for risk that benefits emerging markets is also good for miners. But in fact the two tend to rise and fall together, so buying miners when you already have emerging markets means doubling up on the same risk: you are adding very little to your portfolio compared with just buying more emerging markets.
This danger of doubling up is especially great with funds. It’s a simple mathematical fact that baskets of equities are correlated with each other simply because they are all exposed to market risk. Adding a fund to a well-diversified portfolio might therefore mean more of the same, but with added fees.
We don’t need statistics on correlations to help us avoid this. Think of the future not as a single thing, but rather as a set of possible states of the world – an inflationary state, a recessionary state, a stagnation state, and so on. And then ask of anything you hold or are considering buying: in which states does this pay off well and which badly? If you get lots of the same answers, you aren’t diversifying. That’s not a necessarily a bad thing, if you want exposure to a particular state. Just beware it’s what you are doing.
Ask: which assets offer returns and which insurance?
We should not confine our investments to assets we think will go up, simply because we could be wrong: our knowledge of the future is inherently limited, and we must heed Charlie Munger’s advice to know the edge of our competency.
Some of our holdings, then, make sense as insurance against other parts of our portfolio. While they are unattractive in themselves, they’re useful for our portfolio as a whole. Government bonds, for example, offer negative expected returns. But if you’re worried by the possibility of a relapse in global growth, they have insurance value. Also – and I think more importantly – cash looks unattractive in itself, but is useful insurance not just against falling share prices but against rising interest rates and the difficulty of being able to sell some assets quickly.
What we have here, then, is an example of economists having some useful advice which is not immediately obvious. Such advice can protect us from the twin mistakes of over- and under-diversification, and can help us to manage risks better. There's much more to investing than stock picking.
