As usual, Warren Buffett expressed it best.
“Only when the tide goes out do you discover who’s been swimming naked,” he famously remarked.
And undeniably, for many investors the tide has gone out.
Brexit, electoral surprises, economic shocks – and of course, a global pandemic that a year ago, none of us saw coming.
In each case, investment strategies that appeared rational and sound have been found wanting. Over-exposed to particular equity sectors or asset classes, investors have seen capital values plunge and income shrink.
And with the receding tide, their discomfiture has been laid bare.
Déjà vu
In one sense, it is a little surprising. Many of these investors were around in 2008, which is the last time that the tide went out on anything like this scale.
Even so, the 2016 Brexit referendum and the ensuing shock acted as a reminder, with many UK-centric shares – such as those in the FTSE 250 – experiencing double-digit falls.
So you’d think that most investors would have the right memories or instincts in place.
Seemingly not: the combination of a hunger for returns and over-confidence – especially the latter – is a dangerous brew.
Expect the unexpected
Investors caught without their shorts – or bikini – will of course protest that they didn’t see it coming. And when it comes to a global pandemic, I have some sympathy with that viewpoint.
But only some sympathy.
Because as investors, all of us know that we don’t have a crystal ball, providing 20-20 vision into the future. We have forecasts, and guesses, and predictions, and trends – but they all say what might happen, not what will happen.
So a wise course of action is to expect the unexpected. If something can go wrong, it’s probably best not to assume that it won’t go wrong.
And certainly, even something as unlikely as a global pandemic was top of a very short list of things that the late statistician and epidemiologist Hans Rosling worried about in his excellent 2018 book Factfulness: Ten Reasons We’re Wrong About The World – And Why Things Are Better Than You Think.
Too much of a good thing
So what can investors actually do?
The clue lies in the word ‘over-exposure’. It wasn’t that investors’ reasoning and logic were necessarily wrong – it was that the resulting strategies were pursued to excess.
Post-referendum, UK-focused stocks were a bargain. The resulting logic: load up on them. But not to excess. Ditto banking stocks, pre-pandemic – especially for income investors. Ditto oil and resources stocks.
Ditto just about anything, in fact, if done to excess.
Diversify, diversify, diversify.
Because, as economist and Nobel Prize winner Harry Markowitz (of portfolio theory fame) remarked, diversification is “the only free lunch in finance.”
Risk is reduced, at a modest cost to returns – and indeed, over the long run, arguably no cost to returns.