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Why Are Asset Allocation and Investor Behavior at Odds — Again?

| May 11, 2016
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In the aftermath of the financial crisis of 2007-2008, the average investor ran from the market as though the sky were literally falling.

Why Are Asset Allocation and Investor Behavior at Odds - Again?Many felt that their stocks were actual knives they were juggling, and they didn’t dare catch one by the wrong end.

While in retrospect these similes may seem silly or overly simplistic, they serve a purpose: They describe irrational behavior by investors.

In fact, data from the financial services market research firm DALBAR, Inc. explains that investor behavior is the largest contributing factor to investor underperformance.

The 2014 DALBAR QAIB highlights the futility of investor education, showing that the tendency of investors to make bad decisions persists despite decades of education and disclosures. In fact, the report shows a reversal of the improvement in investor decision-making, capping off the painfully slow improvement of the last three decades. (“QAIB” refers to Qualitative Analysis of Investor Behavior.)

The study explains: “The 20-year annualized S&P return was 9.85 percent while the 20-year annualized return for the average equity mutual fund investor was only 5.19 percent, a gap of 4.66 percent,” according to the report. That gap was an improvement over the 10.65 percentage point gap in 1998.

While much of the slow improvement has been through investor experience and education, the improvement now appears to have stalled.

“It is now past the time for the investment community and its regulators to understand that the principle of educating uninterested investors about the complexities of investing is unproductive,” said DALBAR President Louis S. Harvey. “We need a fundamental change that transforms investment thinking into meaningful decisions and choices for retail investors.”

What factors typically lead investors astray?

  • Recency Bias: The tendency of investors to think that trends and patterns we observe in the recent past will continue in the future is very common. If you couple that with the marketing efforts of an industry primarily driven by the sales pitch, it is easy to see why investors look at the best investments of last year or the last few years as a guide to what would be the best going forward. But as Carl Richards illustrates in his book, The Behavior Gap, we too often lose focus and forget how to judge performance by anchoring to the wrong measure of performance and risk. (More about anchoring in a minute.) The worst part about most investment-oriented publications is that they include almost no references to risk in typical performance rankings. (Read: How much can I lose over any given period?)
  • Herd Mentality: Granted, if everyone you know is buying a certain stock, and the price is going up as a result, you may find yourself wanting to participate in the buying frenzy — even to the point of overpaying for it. But buyer beware, for this type of behavior is how we ended up with the stock market’s Y2K “melt up,” and the housing crisis of 2007.

  • Anchoring:According to investopedia, “The concept of anchoring draws on the tendency to attach or ‘anchor’ our thoughts to a reference point — even though it may have no logical relevance to the decision at hand. Although it may seem an unlikely phenomenon, anchoring is fairly prevalent in situations where people are dealing with concepts that are new and novel.” As I noted above, anchoring can give you the wrong information, and therefore alter your investment behavior. While this is often a normal way of thinking, it can backfire.

What is a more balanced approach to investment decisions?

Asset Allocation. In an asset allocation portfolio, multiple asset classes are owned simultaneously because the future is unknown, and different asset classes perform differently at different times. This is wise because not all assets move in tandem up and down — and when they do, it is not always by the same amount. This is known as correlation.

Therefore, asset allocation is used to reduce the risk of being over-invested in the highest priced (read: riskiest) asset class at the wrong time. And, this approach combats the problem of investors being overly influenced by both recency bias and herd mentality. This approach also takes into account short-term thinking, fear, and greed.

What are retail (read: small) investors doing with their money, and should you worry?

1. No, you should not worry. If you have a broad, asset class based portfolio, and you have correctly identified your risk tolerance, a typical retail investor has still been exiting equities. It is possible that we are far from overcrowded in stocks today.

2. But keep checking yourself. Be careful to fight against normal investor psychology, which too often manifests itself as bad investor behavior.

3. Remember the break-up story. You may have said this when you were dating: “It’s not you, it’s me.” Well, in behavioral finance, it’s not your portfolio — it’s you.

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