The Top 5 Behavioral Hazards For Managing Asset Allocation

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Includes: SPY
by: James Picerno

The technical aspects of designing and managing asset allocation are well known. If anyone’s mystified about the fundamental principles that support and promote enlightened portfolio strategy, it’s not for lack of reading material. Indeed, the literature on this topic is wide and deep, as I discussed in my book Dynamic Asset Allocation: Modern Portfolio Theory Updated for the Smart Investor. Reducing the key lessons down to the essential points leaves us with two recommendations: diversify across asset classes and rebalance. The details matter, of course, but the basic framework is clear. So why do so many investors fall short of respectable results through time? The reasons have little if anything to do with a lack of technical know-how. Most of what we need to know is already available. But there's a glitch, and it comes from within. In sum, behavioral risks are to blame for quite a lot of the disappointing portfolio returns that harass investors.

We know this to be true because behavioral finance has become a major discipline in the world of economics, and for good reason: it explains why homo economicus isn’t always the rational, utility maximizing individual he appears to be in the exploits on the pages of textbooks and research studies. This field of inquiry is relatively new, but the intellectual basis for behavioral finance is no spring chicken. You can find traces of the idea in the writings of dismal scientists as far back as the 1800s. What’s changed is that this area of study has become increasingly formalized, with specialists dissecting how we, as investors, have an unlimited capacity to be our own worst enemies.

On that note, here’s my short list of the five leading behavioral risks that trip us up when it comes to portfolio management. Yes, there are many more than those listed below, which means that the inventory that follows is subjective (yet another behavioral bias?). But while we can argue about what constitutes a leading list of contenders, history suggests that when it comes to asset allocation and rebalancing - the crucial building blocks of enlightened portfolio management - we can’t ignore these behavioral gremlins, which are constantly threatening to undermine our efforts at earning a reasonable rate of return through time.

Running With The Crowd. We’ve all been there. When everyone’s bullish, it’s hard to pare back weights in asset classes that have done well. On the flip side, it’s mentally challenging to tilt the asset allocation into poorly performing assets. The trouble here is that some of this inclination is grounded in common sense. The markets aren’t perfectly efficient, but they’re not anywhere near absolutely inefficient either. In turn, that means that it’s unlikely that you’re going to find a hugely positive expected return for a given asset class that’s been overlooked by the rest of the world. That said, the issue isn’t about making dramatic swings in asset allocation that’s always at odds with the crowd’s bias. Rather, the crucial factor is gradually and continually taking profits while redeploying the proceeds into the unloved areas of the markets. Sure, the timing and trigger-point definitions for rebalancing are open for debate. The bottom line, however, is that you should be prepared to reduce exposure to those asset classes when they’ve delivered strong results and vice versa for assets at the opposite end of the performance spectrum. In other words, lower (higher) prices equate with higher (lower) expected returns when it comes to asset classes. It’s easy to see the logic in this strategy by reviewing history. Thanks to quirks in our wet-ware. However, it’s devilishly tough for most folks to pull off this feat in real time.

Hubris. This behavioral bias covers a lot of ground, everything from overconfidence (mistaking a bull market for genius, for instance) to hindsight (deciding that yesterday’s uncertainty was predictable after all) to self-attribution (attributing your successes to superior brainpower and any failures to external forces beyond your control). That doesn’t mean we should think of ourselves as dummies who are hopelessly ignorant of the world around us. But there’s a fine line between recognizing how markets price assets through time (and acting accordingly) and deciding that we’re smarter than everyone else.

Focusing On Recent History. This is another bias that creates havoc for many investors. Maintaining a healthy perspective on market history requires discipline and a fair amount of study. Even for those of us who dive into the details on a regular basis, it’s easy to get sidetracked with the news du jour. If you’re not careful, last night’s closing prices look like the most important information to the exclusion of everything else. Most of the time, however, the recent price changes are noise. The dangers are particularly obvious when the stock market, for instance, rises or falls by a relatively large degree in a day or week. The move captures everyone’s attention in part because the media rolls out the usual suspects to tell us why everything’s changed as of last night. Granted, sometimes that’s true - think September 2008, for instance. But most of the time it’s just noise. How to tell the difference? We can’t, at least not in real time. Sure, if prices continually rise or fall in dramatic fashion there’s probably some strategic message there ... eventually. But most of the time it’s just the sound and fury of volatility that signifies nothing for strategic-minded investors.

Missing The Forest For The Trees. This is one of the more subtle biases that damage our investment decisions. How many times have you locked your focus on the big winner or loser in your portfolio and allowed that slice of the asset allocation to influence your thinking? It happens to all of us, of course, but it’s no less pernicious as a factor that keeps us from focusing on the far more relevant issue of the portfolio overall. This is a problem that lurks in every corner of designing and managing asset allocation. For instance, we’re hard wired to pick only those assets that we think will deliver strong performance and shun those that are perceived to be dogs. But in the critical task of building and managing a portfolio of multiple asset classes, looking at the elephant’s tail in isolation of the entire beast is setting us up for trouble. The goal, after all, is holding a portfolio that’s reasonably close to optimal, based on our risk tolerance, investment goals, time horizon, and so on. It’d be nice if we could identify ex ante the best-performing asset classes as a regular routine, and thereby ignore everything else. But that’s virtually impossible as a long-term proposition, at least for most investors. The next best thing is designing a portfolio that keeps financial risk to a minimum while shooting for average to above-average returns. For most of us that means spending most of our time managing a portfolio as opposed to a collection of individually chosen assets. But far too few investors take the time to emphasize this broad view. For instance, how does your portfolio compare on various measures of risk and performance with a passive asset allocation index, such as the Global Market Index? If you’re not sure, you’re missing the forest for the trees. It's hard to manage your portfolio if you only see it in terms of its pieces.

Extrapolating From Popular Success Stories. Here’s another area where many investors are led to believe that they’re above average, which leads to all types of problematic money decisions. The classic examples of recent decades is thinking that you could be another Warren Buffett or George Soros. After reading magazine articles and books on these famously successful money managers, it’s tempting to think, well, yeah, I could do that. After all, you’ve read their histories and studied their techniques. But this is a bit like watching the likes of Al Pacino or Jack Nicholson and deciding that the acting life is for you. Heck, look how successful they’ve been. But what’s too often ignored is that for every Pacino or Nicholson there are thousands of actors who aren't superstars. And, of course, there are many failures, a subject that typically draws little attention. It’s the same with investing: a few exceptionally successful names that draw a crowd in a sea of mediocrity or worse.

To be fair, we’re all prone to these and other behavioral biases. The trick is overcoming, or at least managing, the biases. That's tougher than it sounds, particularly across the span of years. But it begins with a simple task: recognizing that the list above poses a genuine threat to our long-run investment results. For some folks, however, even that's asking too much.