Like many Americans, I keep looking out my window for pigs with wings…the euphemism “when pigs fly” having been recently invoked for:
- The Chicago Cubs winning the World Series after a 108 year drought, finding themselves down three games to one to the Cleveland Indians on October 30 (15% probability*)
- Donald Trump winning the United States Presidential election after an aggregated index of national polls gave him less than a 3-in-10 chance to win on November 8 (28.6% probability*)
- US stock market indices reaching all-time highs within 24 hours of November 8th’s unexpected election results, given the plummeting futures markets as election returns were tallied in the early morning hours of November 9th. (Dow Futures down over 5% 1:30am EST 11/9/2016+)
For each of these three outcomes, the odds against them occurring were very long. In other words, those professions specializing in making predictions (bookies, pollsters, certain hedge funds) ended up being wrong in historically significant ways.
In the days leading up to the recent elections, I had the opportunity to speak with a number of audiences and investors about what (if anything) the coming election meant for financial markets and portfolios. As tempting as it was to make a prediction, after 22 years of observing investment market behavior as a “professional,” I resisted, knowing that the odds of making anything like a correct prediction was no better than 50/50.
Sports fans, political observers, and many investors can’t seem to help themselves when it comes to the temptation of making predictions. We watch the news, talk with friends and colleagues, read the pundits, editorials, and analysis, and we believe that we can “see the writing on the wall.” While it’s fun to do this with our sports loyalties, it’s potentially disastrous to act on our predictions when it comes to portfolios.
There were professional and institutional investors on the wrong side of that 5% fall in the value of Dow futures. They were predicting a very negative impact on US stocks as a result of the surprising election outcome. However, as US markets began the trading day Wednesday morning following the election, the Dow Jones Industrials Index opened down a miniscule 0.08% and closed the day up 1.4% at a new record high+. Taking investment actions in line with those negative predictions in the early hours proved very costly.
In a recent whitepaper on the benefits of diversification, researcher Wei Dai, PhD, finds that under many conditions diversification not only reduces volatility, but, “For all investment horizons, there was a substantial increase in the reliability of outperformance as the portfolios become more diversified.”++ Dai was researching US stock portfolio strategies formed around varying degrees of overweighting to value and smaller company stocks and how taking a more or less diversified approach affected results.
For investors who are thinking about how to position their portfolios for higher probabilities of outperformance, Dai’s conclusion supports the idea that consistent diversification over longer time periods is a more reliable strategy for both reducing risk and enhancing return than acting on short-term predictive models using timing models and smaller numbers of stocks.
* Both according to FiveThirtyEight.com a leading statistical modelling website for sports, politics and economics.
+ Wall Street Journal, November 9, 2016
++ How Diversification Affects the Reliability of Outcomes, Wei Dai, PhD, Dimensional Fund Advisors, LP
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