Have you ever done something where the outcome turns out much better than expected and you said to yourself “man, what if I had only bet more on that outcome?” Of course this has happened to you because it’s happened to us all. Whether it was buying a single stock that did really well, placing a bet in a casino or buying the slightly better toilet paper (which, as it turns out, was worth a bigger investment all along).
This is an exceedingly big problem in the financial markets. And it’s particularly difficult to overcome during a bull market. You see, during a bull market you’re likely to have a few big winners. The big winners disproportionately contribute to the positive outcome of the portfolio. In a diversified portfolio this can become even more magnified because your non-stock positions will inevitably leave you wishing you’d had a larger stock allocation.
For instance, if you own a 60/40 stock/bond portfolio you will usually hate that 40% bond piece during the bull market because it makes you wish you’d been 100% stocks. This all or nothing bias tempts you to change the strategy at the worst times. In fact, investors are notoriously prone to chasing the assets that have recently performed well. But what they’re usually chasing is not more return, but simply more risk. And that’s where you get into trouble because it’s during a bull market that you most need to prepare for a potential bear market.
The thing is, that 40% bond piece is serving a crucial role in the portfolio – it’s not necessarily there to beat the stocks. It’s there to beat cash and make you comfortable STAYING in the stock piece so you don’t move to all stock OR all cash. Because we all know that while we’d love to be fully invested during the bull we will totally regret that decision during a bear market.
As I like to say, the key to good portfolio construction is never about building the optimal portfolio.¹ The alpha chase has skewed people’s perceptions into this idea that portfolios must always be perfect or market beating. That’s nonsense. Your portfolio doesn’t have to be perfect all the time. It just has to be appropriate. Getting over the all or nothing bias is a big step towards building a portfolio that is sustainable and appropriate.
¹ – Understanding Modern Portfolio Construction, by Moi