With apologies for the admittedly clickbait title, I’ve got a challenge for you, and I think it’ll make you a better investor. I’ll get to it in just a minute, but first, let me explain why you’re not alone in likely doing this.
We all hear diversification is great. “It’s one of the fundamental tenets of investing!,” we’re told. However, as we look at many of our own portfolios, we find that it’s not actually a reality. We all know about the most common benefit of diversification: smoothing out risk (to be specific, unsystematic risk) which leads to maximized returns. There’s another underrated benefit of true diversification though: it corrects for our natural biases.
As Carl Sagan once said, “Human beings have a demonstrated talent for self-deceptions when their emotions are stirred.” It’s usually that which we know best that gets us most excited. We invest in the stocks of companies we know and understand, but those are usually in the same industry in which we work. Often, it’s believing in your own company and putting your retirement account mostly in the same stock. I began my career at Bear Stearns, the first investment bank to collapse in the Great Recession in 2008. I can’t tell you how many senior bankers there lost everything, as they had invested their savings in Bear stock in the belief that they knew the company better than any other and believed it was solid.
We go on real estate crowdfunding platforms to invest in a variety of properties, yet most people have a bias towards deals in their same city/region where they are often already a homeowner. Trophy geographies like Santa Monica and the Hamptons can elicit Sagan’s aforementioned emotions for investors around the world. For most zip codes though on crowdfunding platforms, you’ll find locals disproportionately investing.
Like in so many areas of our lives, it’s important to confront our biases here and question our portfolio decisions. We can rationalize our over-allocations to the familiar, but as Karen Horney said, “Rationalization may be defined as self-deception by reasoning.”
So here is my challenge to you: As you think about your 2016 investment strategies, start by identifying your biases. Have you only invested in places around the country where you thought you yourself would live? Limited your portfolio to places you’ve actually visited yourself? (I remember one investor who has a superstition about not investing in properties whose street started with a vowel…but she did surprisingly well!) Did you stay out of certain cities or states because of how you imagine it or its residents to be, without actually knowing? Avoided sponsors under or over a particular age?
Now, your rules may work very well and be based upon solid evidence and experience. We use heuristics, or mental rules of thumb, to navigate the world every day. If your goal is a truly diversified portfolio, you’re going to have to let go of some of these. Diversification ultimately comes down to a lack of correlation between the investments that make up your portfolio. What might seem like a very risky investment may actually decrease the risk of your overall portfolio if it has low (or even negative) correlation to the other assets in there. See below to see how different asset classes fared by year:
I did this same exercise at the beginning of the year, and found I’d had a bias against Class B apartment building investments. My unverified assumption was that their pop is limited by an inability to go to Class A if they’re too old while also missing the upgrade opportunities in a Class C building. I’m digging in to verify or dismiss this bias. What are some of your investment biases? I’d love to hear about them! As always, you can reach me at Ray@alphaflow.com.
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About the author:
Ray Sturm is a leading entrepreneur in financial technology, and is currently the CEO of AlphaFlow. Prior to launching AlphaFlow, he founded RealtyShares, one of the P2P industry’s top platforms for real estate investing. His early career in finance included investment banking at Bear Stearns, restructuring at Lazard Frères and private equity at CCMP Capital.
Ray has a BBA-Finance from the University of Notre Dame and a JD/MBA from the University of Chicago.