Diversification - the psychological shield to better investment decisions

IN my last article, I showed that for the past 30 years or so, stock market outperformance has rotated from one region to another every six to ten years. On a three-year rolling basis, US markets have outperformed Asian markets for seven and a half years now. If you are invested only in Asian stocks, it is not hard to see why you would be running out of patience and are entertaining thoughts of throwing in the towel for your Asian equities and shifting your funds to the US.

If you have the urge to do that, you are normal. Humans are commonly afflicted by what is termed "recency bias" - the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to be attracted to an asset class that has enjoyed strong performance - hence valuations are higher and expected returns are now lower - and to shun poor performing asset classes - after their prices have fallen to much lower levels and expected returns are now higher.

For example, given that the S&P 500 Index has risen more than 300 per cent in the past 10 years and nine months, it is hard to imagine it trailing any other stock indices, let alone the totally riskless one-month Treasury bills. Yet it did. Over the 13-year period ending 2012, the 15-year period till 1943, and the 17-year period till 1982, the US equities index lagged the one-month Treasury bills. Of course, in the periods after the poor performance, it went on to produce spectacular returns - returns that were only earned if an investor had stayed the course.