Naïve Diversification and Regret When Investing
It’s no secret that diversification, regular portfolio updates, rebalancing illiquid holdings, and evaluating risk-adjusted performance are essential components of successful investing. But do financial experts consistently practice what they preach? The answer might surprise you.
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).
A Candid Conversation with a Nobel Prize Winner
Take the case of Harry M. Markowitz, a Nobel Prize-winning economist known for developing the Modern Portfolio Theory (MPT). In his book “Your Money & Your Brain,” author Jason Zweig asked Dr. Markowitz how he applied MPT to his investments. The answer was entirely unexpected.
Instead of relying on complex mathematical formulas, Dr. Markowitz admitted to making investment decisions based on his emotions. He split his contributions 50/50 between bonds and equities to minimize the potential for future regret – whether the market soared or plummeted.
Naïve Diversification and Regret When Investing – from Dr. Markowitz
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.
A Brief Overview of Modern Portfolio Theory
MPT is built on several key assumptions:
- Investors are rational and risk-averse.
- The utility function, which represents satisfaction derived from wealth, is concave and shows diminishing marginal utility.
- Investment analysis focuses on a single period rather than multiple periods.
- Investors either maximize their portfolio return for a given level of risk or minimize risk for a given level of return.
The Human Element in Investment Decisions
Despite his groundbreaking work, Dr. Markowitz’s personal investment strategy reveals that even the most knowledgeable investors can fall prey to emotional and cognitive biases. This highlights the importance of recognizing and managing these biases in decision-making.
Investor education is crucial to counteract regret bias and make smarter investment choices. Diversification and asset allocation play a critical role in reducing portfolio risk. Moreover, acknowledging and addressing investors’ behavioral biases can significantly improve portfolio management.
By understanding the human side of investing, you can make more informed decisions and better navigate the complex world of finance.
Disclosure: I do not have any of the securities mentioned above. This article expresses my own views, and I wrote the article by myself. I am not receiving compensation for it. I have no business relationship with any company whose security is mentioned in this article.
Author
Mehmet E. Akgul
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.