Monday 29th of July 2024
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Imagine a world where investors have only two investment options: an aggressive portfolio or a well-diversified one.
The aggressive portfolio is characterised by high-risk, high-reward assets such as Bitcoin or hyper-expensive tech stocks. This portfolio holds the promise of extraordinary gains but also harbours the peril of dramatic losses. On the other hand, the well-diversified portfolio spreads investments across a variety of asset classes, mitigating the risk of catastrophic loss and ensuring more stable, albeit potentially lower, returns.
Alice, a bold and ambitious investor, chooses the aggressive portfolio. She is enticed by the potential for monumental returns and is willing to accept the risk that comes with it. In some scenarios, Alice’s portfolio may skyrocket, yielding immense wealth. However, this strategy is akin to walking a financial tightrope; one misstep can lead to a plunge that might be impossible to recover from.
Bill, in contrast, opts for the well-diversified portfolio. He seeks steady growth and prioritises the preservation of his capital. While Bill’s returns may not reach the astronomical heights that Alice occasionally achieves, his investments are more likely to weather market downturns. Over time, Bill’s portfolio grows steadily, benefiting from compound interest and the stability provided by diversification.
The question arises: which investment strategy is the right one?
The answer lies in understanding the concept of survivorship bias and the critical importance of avoiding catastrophic losses.
Imagine running a simulation with millions of Alices and Bills. Each Alice invests in the aggressive portfolio, and each Bill in the diversified one.
Over time, the richest individuals are likely to be Alices, as their aggressive strategies yield phenomenal returns in rare, favourable scenarios. Imagine a ‘top 10 rich list’ in this imaginary universe… we can show mathematically that they would all be Alices.
These success stories would likely become highly publicised, reinforcing the allure of aggressive investing. The way to get rich is ‘to invest like Alice!’.
However, if we examine the broader population in our model, a different picture emerges. While a few Alices achieve extraordinary wealth, many more suffer significant losses from which they never recover. Their stories are often overlooked in favour of the spectacular successes.
The average Bill consistently outperforms the average Alice over the long run, despite the very top performers being more heavily skewed to Alices. The average Bill’s well-diversified strategy ensures that he avoids catastrophic losses and benefits from steady, compounding growth.
The parable of Bill and Alice underscores a crucial lesson for retail investors: surviving as an investor, by avoiding catastrophic losses, is just as important as achieving high returns.
While the aggressive approach may offer higher expected returns, it also comes with a higher risk of irreversible losses.
While aggressive investments can lead to extraordinary wealth for a few, they carry significant risks that can result in irreversible losses for many. On the other hand, a well-diversified strategy provides more consistent returns and safeguards against catastrophic losses.
In the world of investing, surviving and thriving often go hand in hand. By emulating Bill’s balanced approach, investors can achieve steady growth and financial stability, ensuring they remain on the path to long-term success. So, when faced with the choice between aggressive and diversified investing, remember the wisdom of the parable: be more like Bill, not Alice.
We would like to thank Dominion Capital Strategies for writing this content and sharing it with us.
Sources: Bloomberg, Yahoo Finance, Marketwatch, MSCI.
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