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Diversification and Regression to the Mean: A Profitable Pair
Strengthen your investment portfolio by rebalancing each year. Avoid the common human bias of “doubling down” on previously well-performing asset classes, and take advantage of assets being offered at bargain prices by investing in recent losers.
Consider conventional wisdom on “winning trends” then toss it out the nearest window. When it comes to your portfolio, if you simply assume that the returns of last year’s winners will repeat in perpetuity like episodes of Seinfeld, you’re enabling a dangerous mindset that can inhibit you from maximizing future returns.
With this handy graph, you will be able to see why today’s winner may be tomorrow’s loser. Why? Remember this little phrase: regression to the mean. It’s a phenomenon in which asset classes will gravitate to their average growth over a course of time. For example, take a look at emerging markets returns: these stocks soared 38.7% in 2007 before falling 53.2% the next year. While this is an extreme example that speaks to the liquidity panic of 2008-09, it casts light on the fact that doubling down on recent winners one investment class has the ability to hurt your portfolio.
Want to profit from regression to the mean? Diversifying your investments—also known as rebalancing—is the smartest strategy to deploy. Diversification is the best way to weather any kind of market volatility. Better still, this insulation saves you from rash investing behavior that results from emotions getting the best of you: begging you to double down recent winners, making you more likely to buy at the top of the markets. And the flipside? Rebalancing actually causes you to invest more of your money in last year’s losers, those assets classes that motion has you staying far away from yet may offer great investments at bargain prices.
To achieve a diversified investment portfolio, and make sure you’re set up for long-term success, you have two goals:
- Invest broadly across assets.
- Invest broadly across markets.
Investing broadly across assets is the opposite of doubling down on one company’s stock. Doing so leaves you open to diversifiable risk—pretty much the same as putting all your eggs in one “oh-so-adorable-we-bought-it-on-Etsy” basket. Spreading those eggs out over many industries and companies saves your portfolio from unnecessary risks and volatility.
Investing broadly across markets is dipping your portfolio in several asset classes. It is near impossible to know which asset classes will outperform others from year to year, so save yourself the stress and heartache of only picking one winner (that most likely will not win) by increasing your odds by investing in a whole roster of potential winners.
When it comes to investing, the simple mentality is not conventional wisdom. Just remember: don’t double down, diversify! Frontrunners are great to get behind in sports, but leave that strategy there when it comes to your investment portfolio.