Investors routinely face events for which the outcome is unknown. In recent months, for example, investors contended with the uncertainty that was Brexit, and now they wonder when/if the Federal Reserve will increase interest rates and who will win in the November U.S. presidential election. Events of this nature are naturally unnerving because they are uncertain and because they are complex macro events in which it is rare to have an investment edge.
Many investors deal with events that are fundamentally uncertain by trying to “figure them out”—i.e., guessing which outcome is most likely, then positioning themselves around that view. Unfortunately, this can be a fragile strategy. When you don’t have an edge and things are uncertain, a more resilient approach is to diversify. Instead of positioning yourself for one outcome only, you make sure you can withstand many potential outcomes. The virtue in this approach is that it keeps you alive to live another day.
Imagine your sister is getting married to Mr. Spock. In the process of planning her wedding, she discovers there is a 60% chance of sunshine and a 40% chance of rain. Although she really wants her wedding outside by the lake, Mr. Spock suggests that they hold the wedding in their backyard instead. Her fiancé logically concludes that the backyard is still sufficiently pleasant and, if it does rain, the location would allow guests to get only a little wet as they run inside. Obviously, it’s an option that is sub-optimal and yes, the backyard is not as nice as the lake when it’s sunny, but taking this option prevents the more calamitous possibility of everyone getting drenched.
Although placing all your bets on a 60% chance of sunshine sounds silly, it is the way many investors approach macro events. Even when the probabilities are very close—as they were with Brexit—they select the scenario that seems the most probable and then treat it like it’s a certainty. This is illogical! In the wedding example, you shouldn’t be surprised if it rains: it should rain 4 out of every 10 weddings.
Now let’s imagine that your sister and Mr. Spock were just married. As it happened, they opted to host the wedding in the backyard as Mr. Spock suggested and it turned out to be a beautiful sunny day. Your sister is visibly upset. “See!” she informs her husband, “I TOLD you so. I knew it would be sunny.” You watch as Mr. Spock tries to reason with his wife but by this point your sister has already concluded she was right all along.
But of course, she was not. Just because it turned out to be a sunny day doesn’t mean the decision to diversify was wrong. This is a common pitfall people fall into. We tell ourselves “I knew better!” when, actually, we did not.
A diversified approach is appropriate when you expect to go through many uncertain events. Obviously, you are hoping to only get married once, but in investing, you go through many events. This is a good thing for investors because while your experiences may occasionally be negative, the fact that you go through multiple events means that you have the chance to overcome the bad ones. If there is a 60% chance of sunshine, and enough weddings occur, the weddings will be rain-free most of the time. This is how it works in your portfolio, too. If the odds are in your favour overall, and you go through enough rounds, the overall outcome should be positive.
Uncertain macro events, like Brexit, happen regularly and investors must contend with them. Sometimes it is possible to have an edge in these scenarios, but most times it is not. Diversification is the appropriate strategy to take when you don’t have an edge—even if that means getting married in the backyard instead of the beach.