In the 1993 comedy, Groundhog Day, Bill Murray stars as Phil Connors. In it, he finds himself living the same day over and over again. The repetition allows him a unique ability to make incremental improvements to his life, but also highlights the importance of making the right choices the first time, because you don’t always get do-overs. If he had made the right decisions from the beginning, it would have saved himself a lot of effort. In investing, replaying the same day over and over again is how professionals build models and the probabilistic outcomes of success – which is helpful for planning but doesn’t get to the heart of the matter which is path dependence.
Path dependence is a crucial aspect of decision-making and problem-solving. So much so, that we do it every day, without even thinking about it. It refers to the idea that our choices and actions impact future outcomes, sometimes significantly. Imagine picking a different chosen profession or joining a different social club? How different could your life have been? No matter what the answer to that question is, life can never be replayed.
Risk management is a critical consideration in portfolio construction since investors only have one experience to live, and volatility is plentiful in the financial markets. On average, there are 1.2 declines per year that are more than 10%. A 10% decline would require roughly an 11% return to ‘get back to breakeven’ whereas a 30% decline requires nearly a 50% return.
Past performance is not indicative of future results, meaning tomorrow is uncertain and does not have to be the same. Because of this investors need to consider the implications of how their portfolios are constructed.
Diversification is the risk management tool described as a ‘free lunch’. Proper diversification is less dependent on the amount of ‘stuff’ owned, and more about owning the right stuff. Many times, investors will buy a lot of ‘stuff’ and have a bunch of securities that all overlap and are overly similar. These investors then consider themselves diversified, even though they own a lot of the same things.
Let me explain this more simply and apply this same concept to Cheerios. There are a lot of “O’ cereals out there to choose from; being the “good” breakfast connoisseur you are you, decide to have plenty of options for the first meal of the day. You decide to buy Cheerios, Cascadian Farm Organic Purely O’s, Trader Joe’s Joes O’s, and Nature’s Path Organic Whole O’s. Now, who is going to come to your house and say you have a lot of options for breakfast? No one. Yes, you have a lot of boxes of cereal, but they are practically the same cereal in a different box and no one would call this “variety.” Unfortunately, this is exactly what a lot of investors' portfolios look like; a lot of the same stuff with different names.
True diversification helps mitigate path dependency because it offers the benefits of investments going up when others are going down, and the reasons for this are structural in what they do or how they are managed. It has nothing to do with the number of things owned and everything to do with what is owned. The goal of owning the right diversifiers is to make it palatable to withstand large market drawdowns, which are not uncommon; In fact, 24 of the years since 1980 have had drawdowns worse than 10%.
In Groundhog Day, Phil gets a redo when he keeps waking up over and over. He can make a change tomorrow if he didn’t like the result today because he’s going to live it over again. With investing and life, we don’t get the do-over. We have to do it right the first time and that’s why we believe investor portfolios need to be prepared in advance for the best shot at weathering the next economic storm. We don’t always know when they’ll come or what they’ll bring, but we don’t have to relive any day to know that another economic storm will come.
The best tools for managing economic storms come from true diversifiers – hedging with the financial tools available, and when appropriate using a variety of investments and strategy solutions designed to offer a benefit at various points in the financial market cycle. We’re optimistic and hopeful for the future while remaining steadfast in our belief that downside risk is a detriment to the success of all portfolios.
Disclaimer: This publication is intended for information purposes only and should not be construed as an offer or recommendation or solicitation for sale, purchase or engagement in any other transaction. We do not provide any warranties or representations for the content of this publication, in particular not with respect to its accuracy, completeness or fair balance, and no liability is accepted. Investing is risky and the risk of loss exists in all types of investments. This information does not replace any investor's own due diligence, legal, suitability, or tax situations.