When presented with evidence that investment B is inferior to investment A, a common human reaction is to decide to invest less money in investment B rather than none at all. This kind of thinking may be what is behind some investment choices.
To illustrate what I mean, imagine that you’re playing a game where several decks of cards are shuffled and then you have to guess whether each of the top 16 cards is a spade or not before it is turned over. When asked what the best strategy is, a common response is to choose “not spade” 3/4 of the time and “spade” 1/4 of the time.
However, the strategy that maximizes the number of correct guesses is to guess “not spade” every time. The “not spade” strategy is expected to be right about 12 out of 16 guesses. The mixed strategy will guess “not spade” 12 times and get about 9 right, and will guess “spade” 4 times and get only one right, for a total expected number of right answers about 10 out of 16.
How does this relate to investing? We have many different justifications for allocating a small amount of our savings to investments we believe are inferior. For example, some advocate owning a small amount of gold. Gold has performed poorly over the long haul, but many people think they should have a little.
We are often told that it’s okay to invest the bulk of our savings in solid investments and allocate a small amount of “play money” to invest in dubious high-risk stocks. Others advise investing a small amount in some particular emerging market or market sector, but this makes little sense if we know nothing about that emerging market or market sector.
This idea of investing small amounts in dubious investments is often justified in the name of diversification among uncorrelated assets. This is a worthwhile goal to a point, but beyond a certain point, the benefits are minimal and do not compensate for the loss in expected return.
There can be good reasons for owning a variety of assets, but it should be based on serious thought rather than simply averaging out all the advice you hear.