Naïve Diversification and Regret When Investing

Nearly all finance and investing books, writers, and academics mention diversification, periodic portfolio updates, rebalance illiquid holdings, and risk-adjusted-performance evaluations. Do you think these finance professionals consistently implement these strategies to own their lives?

As you may guess from the beginning of the article they don’t. Jason Zweig, the writer of “Your Money & Your Brain”, asked Harry M. Markowitz, who holds a Nobel Prize in economics in 1990 for developing the theory of portfolio choice (a.k.a. Modern Portfolio Theory).

stock market

Dr. Markowitz's Portfolio Application In Real-World

Dr. Markowitz proved the importance of diversification. In modern portfolio theory, risk-averse investors allocate investments into diversified portfolios through mathematical formulations with mean-variance analysis and covariance between assets and/or asset classes. However, Dr. Markowitz told Mr. Zweig, that isn’t what he did:

Instead, I visualized my grief if the stock market went way up and I wasn't in it – or if it went way down and I was completely in it. My intention was to minimize my future regret. So, I split my contributions 50/50 between bonds and equities.

Modern Portfolio Theory

Dr. Markowitz has some of the following assumptions for the modern portfolio theory:

  • An investor is risk-averse and rational.
  • The investor’s utility function is concave and shows the diminishing marginal utility of wealth.
  • Investment analysis is based on a single period, not a multi-period approach.
  • An investor either maximizes his portfolio return for a given level of risk or maximizes his return for the minimum risk.

Conclusion

As most investors do, he apparently doesn’t take his advice and represent regret behavior in the decision-making process. We accept what risk-averse investors do with investment allocation, but we represent our investments’ emotional and cognitive behavioral biases.

In order to overcome regret bias, investors’ education is necessary. Diversification and asset allocation help to reduce portfolio risk. Investors’ behavioral biases need to be considered in the portfolio management. 

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Author

Covers investment, financial analysis and related financial market issues for BrightHedge. He has extensive experience in portfolio management, business consulting, risk management, and accounting areas.

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The investment information, comments and recommendations contained herein are not subject to investment advice. The comments and recommendations contained herein are based on personal views. These views may not fit your financial situation and your risk and return preferences. For this reason, based only on the information contained herein, investment decisions may not have the appropriate outcome.