A basic investing principle to help you invest better, focus on a diversified portfolio This goes on year after year, decade after decade. The right strategy is to keep investing steadily in a diversified manner
Dhirendra Kumar
CEO, Value Research
Have you heard the Bob Dylan song, where he explains one of the basic principles of investing? The lyrics go as follows: ‘For the loser now, will be later to win.... and the first one now, will later be last’. While Dylan had no intention of expounding on the workings of the financial markets, the lyrics perfectly sum up the principle of ‘reversion to the mean’. Here’s what GPT4 says about this theory: ‘In finance, reversion to the mean refers to the assumption that the price of an asset will move towards its average price over time. If the price of the asset has been above the mean, it is expected to decrease in the future, and if it has been below the mean, it is expected to increase.’
While this definition refers to stocks, it’s just as applicable to almost all financial assets, including the markets. This is the reason it makes little sense to get too excited about the markets zooming to all-time highs or specific parts of the markets doing fabulously well. Similarly, it’s pointless to get panicky when the markets fall too sharply. The problem arises because investors do not understand the underlying idea and assume that the ongoing trend will continue. Of course, in this belief, they are aided and abetted by those who stand to make money from them.
The reasons for investing in the market segment that is doing well at any given moment are easy to pass off as research. Professionals (brokers, advisers, fund companies), as well as individual investors, can always justify investing in an industry by pointing out that it is doing better than the others, the assumption being that it will continue to do better. If this excitement sustains long or strongly enough, it becomes conventional wisdom, something ‘everyone’ knows. In sectors, this happened with tech stocks during the heady days of 1999, and we all know how that ended. Around 2005-7, it happened to a set of industries that were loosely defined as ‘infrastructure’. That ended up being as big a blowup as tech in 2001.
This also occurs in specific segments of the market, such as small caps. These are especially prone to this phenomenon because their deviations from the mean are most severe. When they do well, they do really well. It’s easy to convince investors or, perhaps, easy for investors to convince themselves that this means something when it doesn’t. When a sector or segment sustains better than average performance for a noticeable period of time, a bandwagon is created around it. Fund companies launch funds or start pushing the ones that already exist. Investment advisers start talking about it, seeing a clear short-term win if the trend holds. For a while, the trend does hold. At this point, it looks sub-optimal to invest in a diversified manner. The thing to understand is that this happens almost every time. Since one or the other sector is certain to be performing better than the average, having a diversified portfolio always seems to be a foolish choice.
However, the averages assert themselves eventually, the segment starts performing below average, and the returns revert to the mean. Those who join the party late are left with a negative outcome. The reversion to mean often results in the formerly best segment falling to the absolute bottom and creating losses even when the rest of the market is booming. This goes on, year after year, decade after decade. The right strategy is to keep investing steadily, in a diversified manner, preferably through systematic investment plans (SIPs). It’s not complicated, but avoiding the hype requires a lot of effort.
(The author is CEO, VALUE RESEARCH.)
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(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
This story originally appeared on: India Times - Author:Faqs of Insurances
