WHAT IS OCCAM’S RAZOR?Occam’s Razor is a principle attributed to William Occam, a 14th century philosopher. He stressed that explanations must not be multiplied beyond what is necessary. Thus, Occam’s Razor is a term used to “shave off” or dismiss superfluous explanations for a given event. This concept is largely ignored within the investment management landscape. This newsletter will “shave off ” popular investment misinformation and present what is important for achieving long-term investment success.

With all of the recent uncertainty surrounding the situation in Greece, we want to provide an update on your exposure to Greece in your portfolio, while also discussing the whole situation and markets in general.

If you would like a review of just how we got to where we are, it’s tough to beat Prof. Anil Kashyap’s timeline (pdf). It’s relatively short, but provides a clear explanation of the important events leading up to the referendum this past weekend.

At this point, it is unclear what Greece, their creditors, and the markets will do. While we cannot tell the future, we are comfortable with the range of possibilities. At this point, it appears that pretty much everything is on the table – from Greece agreeing to the terms set by their creditors; Greece leaving the Euro and paying everyone in Drachma; or, of course, default.

Greece is a Small Economy

Greece is a small country. As of May 31, 2015, Greece represented 0.04% of the world stock market, which translates to a market value of $18.3 billion*. This sounds like a lot, but as a point of comparison, Hess Corporation, an oil and gas company, had a market cap of $18.9 billion, as of June 2, 2015**. If Hess had financial difficulties, it would barely register for most people, unless you fuel up at a Hess station.

Looking at how Greece stacks up to other countries, the next biggest country by market cap is Portugal, with almost twice the market value of Greece ($33.2 billion for Portugal, and $18.3 billion for Greece as of May 31, 2015). The next smallest country, Peru, is actually much closer to Greece’s size with a market value of $13.5 billion as of the end of May.

If you had $1 million invested in a globally diversified equity portfolio that held everything at market weights, you would only have about $400 invested in Greek stocks.

This is Why You Diversify Your Portfolio

Situations like the Greek financial mess are part of investing in the stock market, and it’s why we stress diversification so strongly. When you take on risk beyond short term US Treasuries, there will be periods where you have bad returns. You can do everything right, and still, in the short term, the market can move against you. Just focus on building the best portfolio possible to capture the amount and types of risk you want to take.

The first step toward the best portfolio is full diversification. A fully diversified portfolio includes pretty much every stock out there. Owning the market helps you avoid focusing on the ups and downs of specific companies, sectors or countries, allowing you instead to focus on the long-term growth of the world economy. That “long-term” part is important. A fully diversified portfolio will still have good years and bad years, but it allows you to intentionally build your portfolio around the types of risk factors the market pays you to take.

So what are those risk factors? You should be focusing on the dimensions of risk that, in the long term, are reliable, robust and persistent. Some of them are straight forward — stocks are riskier than bonds. Others are a little more involved, such as value and profitability risk. The common element of all desirable risk types is a positive expected return. The market compensates you for taking on that risk.

For more information on how diversification works, as well as the types of risk we think you should be building your portfolio around, you should take a look at our articles on diversification and taking risks that make sense.

Market Prices are Based on Expectations

We often get questions during volatile situations asking whether you should simply eliminate exposure to the area in question, be it Greece, Russia during the height of the Ukraine conflict, or whatever country is currently having economic troubles. The big reason you shouldn’t get in and out based on events is that market prices are based on expectations. The market does not wait for something bad (or good) to happen.

Markets incorporate all available information, so if there is a possibility that something will happen, that possibility is priced in. By the time you decide to pull out of a portion of the market, prices have already adjusted based on the market’s perception of relative likelihoods. You’ve already experienced some portion (probably a large one) of the downside you are trying to avoid, so getting out just puts you at risk for missing the recovery. You would likely play right into the typical “Buy High, Sell Low” scenario, selling when prices are low, and buying back in when prices are high — something you want to avoid

This applies to the possibility of a “contagion” should Greece default or leave the Euro. The market is constantly watching what is happening in Greece, trying to determine its impact on the rest of Europe and beyond. These assumptions help market participants decide how much they are comfortable paying for a stock, meaning the possibility of a contagion is already priced in. If Greece were to default or leave the Euro, stock prices would most likely decline as a result of the uncertainty being removed, not the market failing to anticipate it. This situation, like all situations in the market, is driven by new information.

I can imagine a scenario where Greece and its creditors get everything straightened out and the Greek markets enjoy a great recovery. I can also imagine a scenario where everything falls apart. The important thing is that you shouldn’t trade on this. I don’t know better than anyone else what’s going to happen, but both possibilities — and everything in between — are already incorporated into the value of the Greek market. We can hope for a full recovery for Greece and rest safe knowing that we are safe from the worst.

To sum up:

  • Greece is a very small part of the world economy. It represents only 0.04% of the world market value. A $1 million, fully diversified world portfolio would have about $400 invested in Greece.
  • This is why we diversify. Situations like these are part of investing, so it is important to be invested in essentially everything and focus on taking risks that make sense.
  • Markets react to events almost instantaneously. Moving in and out based on what you think is going to happen in the future doesn’t work.

If you have any other questions on Greece, our investment philosophy, or anything else, contact your advisor, or reach out to us directly.

*Data from Dimensional Fund Advisors.

**Data from Yahoo Finance.

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