We Don’t Know What Will Win Next. That’s the Point.
One of the most seductive ideas in investing is that if we analyse markets carefully enough, we should be able to work out what will perform best next.
Australian shares?
International shares?
Small companies?
Property?
Bonds?
Cash?
Growth?
Value?
The temptation is understandable.
If we could identify tomorrow's winner today, investing would be easy.
The problem is that markets rarely cooperate.
Yesterday’s winner is often tomorrow’s disappointment.
Look at almost any long-term chart comparing investment markets or asset classes and one thing quickly becomes obvious: leadership changes constantly.
The best-performing asset class in one year can be somewhere near the bottom the next.
An area that has disappointed investors for several years can suddenly become one of the strongest performers.
Investment styles come in and out of favour.
Growth can dominate for a period.
Then value returns.
Large companies lead.
Then smaller companies have their turn.
Australian shares outperform international markets.
Then the reverse happens.
The pattern is not random in the strict mathematical sense. There are economic forces behind these movements. But reliably predicting the sequence in advance is extraordinarily difficult.
That matters because investors are often encouraged to behave as if it is possible.
The investment industry loves a forecast
There is never a shortage of predictions.
Interest rates will rise.
Interest rates will fall.
The Australian dollar will strengthen.
The Australian dollar will weaken.
Technology shares are too expensive.
Technology shares will continue to dominate.
A recession is coming.
A recession has been avoided.
Some of those forecasts will prove correct.
The problem is knowing which ones.
And even when the economic forecast is right, the investment conclusion can still be wrong.
Markets are forward-looking.
Prices already reflect the expectations of millions of investors.
A company can report excellent results and its share price can fall because investors expected even better.
An economy can look terrible and its sharemarket can rise because investors believe the worst is already behind it.
That is why investing is not simply a matter of predicting the economy.
Diversification is an admission of uncertainty
Diversification is sometimes described as a way of reducing risk.
That is true, but I think there is a deeper reason for it.
Diversification is an acknowledgement that we do not know what will happen next.
We do not know which asset class will perform best.
We do not know which investment style will be in favour.
We do not know which country will lead.
We do not know exactly when the next market correction will occur.
And we do not need to know.
A properly diversified portfolio is designed so that no single prediction has to be correct for the financial plan to work.
That is a very different mindset from trying to identify the next big winner.
Diversification means accepting disappointment
There is an uncomfortable truth about diversification.
If a portfolio is genuinely diversified, something in it will almost always disappoint you.
When Australian shares are booming, international shares may look unnecessary.
When technology shares are soaring, value managers can appear out of touch.
When growth assets are performing strongly, cash and defensive assets can look like dead weight.
That is normal.
In fact, if every part of a portfolio is performing brilliantly at exactly the same time, it may be worth asking whether the portfolio is really diversified at all.
Different investments are supposed to behave differently.
That is part of the reason they are there.
The danger of chasing what has already worked
Human beings naturally gravitate towards recent winners.
We feel more comfortable investing in something that has been going up.
It appears safer.
It appears more obvious.
And we can usually find plenty of commentary explaining why the strong performance will continue.
Unfortunately, this can lead investors to buy after prices have already risen substantially.
At the same time, areas of the portfolio that have disappointed can feel increasingly uncomfortable.
The temptation is to sell them and move the money into whatever is currently working.
That can create a damaging cycle:
buy what has recently risen, sell what has recently fallen, repeat.
It feels logical.
But it can become the exact opposite of disciplined investing.
Rebalancing turns uncertainty into discipline
This is one reason we rebalance portfolios.
Suppose a portfolio starts with a planned allocation to Australian shares, international shares, defensive assets and cash.
Over time, some areas perform better than others.
The proportions change.
Rather than allowing yesterday's winners to dominate the portfolio, rebalancing brings the investments back towards their intended allocation.
That can mean trimming something that has performed strongly and adding to something that has lagged.
Emotionally, that is often difficult.
But that is precisely why having a process matters.
We are not saying the lagging investment is certain to outperform next.
We are saying we do not know what happens next, so we maintain the diversification we deliberately established in the first place.
The same principle applies to fund managers
Diversification does not stop at asset classes.
Even within Australian shares, different managers can approach the market very differently.
One may focus on companies with strong growth prospects.
Another may be more disciplined about valuation.
One may favour large established businesses.
Another may look further down the market for opportunities among smaller companies.
No style works all the time.
That is why we generally prefer not to build an entire portfolio around one manager's view of the world.
The objective is not to find the one manager who will always be right.
In our estimation, such a manager does not exist.
The objective is to combine different approaches so the portfolio does not rely too heavily on any one of them.
Good investing can feel uncomfortable
One of the strange things about investing is that a sensible portfolio can frequently make you feel as though you are doing something wrong.
You will see another investment doing better.
You will read about a fund that has topped the performance tables.
Someone you know will tell you about the share they bought that has doubled.
There will always be something you wish you had owned more of.
That is unavoidable.
But investing is not about owning everything that goes up.
It is about having a sensible strategy that gives your financial plan a reasonable chance of succeeding across a wide range of possible futures.
We don’t need to predict the future
At TUI, we do not build portfolios on the assumption that we can consistently forecast markets.
Quite the opposite.
We start with the assumption that the future is uncertain.
We diversify across assets.
We diversify across managers.
We diversify across investment styles.
We maintain liquidity.
And we rebalance when markets cause the portfolio to move away from its intended structure.
Not because we know what will win next.
Because we don't.
And that is the point.
The goal of a portfolio is not to perfectly predict the next winner.
It is to remain robust enough that your financial plan does not depend on making that prediction correctly.
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