Last Updated Jun 4, 2010 8:07 AM EDT
A good example is relying too heavily on credit ratings when it comes to fixed income investments. During the credit crisis from 2007 to 2009, many bonds with weaker credit ratings performed better than bonds with much higher ratings.
- Why? Because some of the highest credit ratings went to companies in the financial services sector. And if you just followed the ratings, you would have ended up with a high concentration of bonds in financial services firms. When in reality you may have been better off owning a diversified basket of bonds with slightly lower ratings but in different industries.
- The reason so many financial services firms got into trouble was because they gorged on one type of AAA rated security. When those securities collapsed, so did the firms. Investors assumed that AAA or AA ratings carried some sort of immunity against financial losses, and never looked at what sort of bonds constituted that pile of AAA stuff. Investors were lulled into a false sense of security by the high ratings.
- Think about this in relation to another industry such as aviation. If we want to design a plane, we have to make certain assumptions about the force of gravity. Well, if the force of gravity could suddenly doubled one afternoon, planes couldn't get off the ground or stay in the air. That would make flying a lot more risky.
- If you rate a financial product based on certain assumptions about the volatility of prices, and then that price volatility suddenly doubles or triples, your ratings won't reflect the realities of the risks.
- The problem with most of the mortgage backed securities was that they were structured assuming housing prices wouldn't decline. Then they fell by 40%. When you're dealing with assumptions that can change so quickly and violently, it makes all risk assessments difficult.
Then in 2007, many highly rated funds had concentrations in financial services firms and real estate investment trusts, and of course you know how that ended.
The problem with financial ratings is they're backward looking. They rely heavily on how things have performed in the recent past (often the last 3 to 5 years), but markets change quickly. So by following the ratings too closely, you can end up owning lots of things that wont' do well during the next market or economic cycle.
Yet, people still love to rate and rank financial products because we want to assign more certainty to the investment process than is really possible. And it's easier to market things that way.
But if you accept that there is an inherent amount of uncertainty associated with determining the quality of any investment, then you come to the decision that you also need to diversify your holdings. Diversification can serve as a hedge against poor judgements or mistaken assumptions.
Bottom line. Don't rely too heavily on the number of As, stars or smiley faces someone assigns to a particular investment.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.