A basic investing principle to help you invest better, focus on a diversified portfolio

Have you heard the Bob Dylan song where he explains one of the basic principles of investing? The song's lyrics go as follows: "For the loser now, will be later to win.... And the first one now, will later be last". While Dylan had no intention of expounding on the workings of financial markets, the lyrics perfectly sum up the " reversion to the mean" principle. This is what GPT4 says about this theory: “In finance, reversion refers to the assumption that the price of an asset will move toward its average price over time. If the price of an asset is above the mean, it is expected to decrease in the future and has been below the mean, it is expected to increase.

Although this definition refers to stocks, it applies equally to almost all financial assets, including markets. This is why there is no point in getting too excited about markets approaching all-time highs or certain parts of the markets doing great. Likewise, there is no point to get panicky when the markets are going down very sharply. The problem arises because investors do not understand the basic idea and assume that the current trend will continue. Of course, in this belief, they are aided and abetted by those who are willing to make money on them.

It's easy to go through research reasons to invest in a market segment that is doing well at a given time. Professionals (brokers, advisors, finance companies) as well as individual investors can always justify investing in an industry by pointing out that it is doing better than others, assuming it will continue to do better. If these feelings persist long enough or strongly enough, they become conventional wisdom, something that "everyone" knows about. Across sectors, that was the case with technology stocks during the strong days of 1999, and we all know how that turned out. Around 2005-2007, this happened with a group of industries loosely defined as "infrastructure". It ended up being as big a blast as the technology was in 2001.

This also happens in certain segments of the market, such as small businesses. These are particularly prone to this phenomenon because their deviations from the mean are more severe. When they do it right, they do really well. It's easy to convince investors, or perhaps easy for investors to convince themselves, that this means something when it really doesn't. When a sector or segment maintains sustains Better than-average performance for an noticeable period of time, a bandwagon is created around it. Fund companies release funds or begin to push existing funds. Investment advisors start talking about it, seeing a clear gain in the short term if the trend holds. For a while, the trend does hold. At this point, diversified investing seems suboptimal. The thing to understand is that this almost always happens. Since one sector or another is bound to perform better than average, having a diversified portfolio always seems like a fool's choice.

However, the averages assert themselves eventually, and the segment starts to perform below average, and falls back to average. Those who join the party late are left with a negative score. The reversion to mean often results in the formerly best segment falling to the absolute bottom and creating losses even when the rest of the market is booming. And this continues, year after year, decade after decade. The right strategy is to continue to invest steadily, in a diversified manner, preferably through Systematic Investment Plans (SIPs). It's not complicated, but avoiding the hype requires a lot of effort.

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