Systematic Methods Trump Bad Behaviors

Feb. 08, 2013 4:59 PM ET
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While going through the Seeking Alpha site yesterday, there was nice article by Russ Koesterich, the Global Chief Investment Strategist for BlackRock's iShares ETF business. He lays out three common bad behaviors of individual investing which we agree with.

1. Stock Market Avoidance

Many people avoid risky assets like the stock market despite the high cost of staying out of such investments, particularly in the current, low-yield environment because they are roughly twice as sensitive to losses as they are to gains, and tend to evaluate performance over too short of a time frame compared to their actual investment horizon. At Bloodhound, we promote long-term investing - not necessarily owning the same investments, but following the same strategy. Timing cycles doesn't work for most.

2. Insufficient Diversification

Investors have under-diversified portfolios. In a 1991 to 1996 study of the customers of a large US discount brokerage, more than 25% held only one stock, and more than 50% held three or fewer stocks. However, a well-diversified portfolio should include at least 10 to 15 stocks, which only 5% to 10% of the investors held in any given period. We recommend portfolio sizes between ten and twenty stocks. Our model strategies are structured with portfolios of 10-, 20- and 50-stocks for comparison purposes.

3. Inefficient Trading

Excessive trading can hurt profits. There are a number of reasons for excessive trading. One major one is that people tend to be more likely to get rid of stocks that have done well in the past, and to keep the losers so as to avoid the mental pain associated with realizing losses. In behavioral finance, this latter concept is known as "the disposition effect." When confronted with their cost basis, many investors hold losers for a "better day." In my years of portfolio management, I always tried to keep a mindset that every day you walked in the door you were buying that portfolio anew. The cost basis was irrelevant. If you didn't like buying it at today's level, you shouldn't own it. A systematic plan for buying and selling is always best.

Russ would probably like us. His final comment is fitting. "Consider rebalancing a portfolio periodically with a rules-based or systematic investment approach to help lessen investor biases."

Couldn't agree more.

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