My wife and I each like to read and Magazines are part of our fare. One of her favorites is ‘O’ ,Oprah Winfrey’s magazine. Each time she gets a copy I ask “Who’s on the cover of ‘O’ this month?”. Of course, those familiar with the publication know that Oprah Winfrey herself graces each and every cover of the magazine. While this is highly unusual for most publications it is not for ‘O’.
It points out that as humans we tend to focus on what we know and become familiar with. It would be a shock for anyone else other than Oprah to be on the cover of ‘O’ but just as weird to see the same person on the cover of Time each month. When it comes to our assessment of risk in investment portfolios we are often subject to the same biases. For example, when it comes to the stock market when we hear or read in the media that “that market reached record highs today” when immediately become concerned that we have “waited too long” or we are about to “get hit” with a precipitous decline.
The reality is that the equity markets (as measured by the S&P 500 Index ) is trading at about 15 times earnings versus over 30 times earnings in 2000 before the last bear market. So does the market reaching new record highs have any relevance in an investors thinking? The answer is more complicated than that. What are the relative valuations? Is the economy growing or contracting? What are the likely prospects for the future of economy and the stocks involved?
But how much of this is dictated by our human biases? Is Oprah going to be on the cover of ‘O’ this month? Will things change? Recently I read “The Black Swan“. The author, Nassim Nicholas Taleb, also wrote “Fooled By Randomness”. Taleb points out that what is really important is not what know or “think” we know but rather what we don’t know or is not on our radar screen that is important.
For example, few would believe 24 months ago that the residential real estate market would be in the situation it is in many parts of the country AND if the POSSIBILITY of a decline in housing prices could happen one would be presented with all sorts of facts showing that this idea has no merit. Now the evidence is obvious that the signs were there 24 months ago and were largely ignored.
If our command of the facts and beliefs about them are so unreliable what should an investor do in implementing a portfolio strategy in their wealth management plan? Duck and cover? This would lead to the increasing our risk of not achieving our objectives by not achieving a reasonable rate of return. Only be diversifying among a variety of investment types choosing not what we believe will be the best performer but rather choosing asset classes that have low correlations which other. In implementing a multiple asset class portfolio strategy one allows for the ‘unknown’ not to bite you or allow you to benefit by the unforeseen new reality. Well constructed portfolio strategies can improve the probability of success in achieving wealth management goals and objectives. If Oprah is not on the cover of ‘O’ next month a well designed portfolio strategy can insulate people from the ‘improbable events’ we are certain to face.