The Bulls & Bears of Behavioral Finance
The buy low/ sell high concept looks wonderful on paper – but is a bear to implement. While the market may be rational and efficient over time, most investors are not.
How we manage our emotions is a significant factor on investment success, yet very few of us manage emotions properly. Keeping your emotions in check can have a considerable impact on your long term results and sustainability.
Quantitative studies by leading research firms on investor behavior indicate that many main street investors underperform the S&P 500 index by about 67% or more over time (Dalbar, 2014). This significant “behavior gap” is a clear example of the perils of investor psychology to emotionally take action on short-term news and market information.
This “herding mentality” conditions investors to manifest in chasing the latest top performing market, asset class or security–buying it at the peak (greed), riding it down (remorse) and then selling at the bottom (fear.)
Through the power of asset allocation and diversification, you can help to reduce the volatility in your portfolio while seeking to improve its performance over time. More importantly you can work to develop and implement a focused, disciplined and less emotional approach to managing your wealth.
Diversification is the fancy name for the advice your mother might have given you: “Don’t put all of your eggs in one basket.”
In essence, diversification is an important risk management tool that is characterized by how positions move in correlation with each other. By having investments that are negatively correlated (such as stocks to bonds) your over-all volatility can be reduced.
The time to practice disciplined investing with a diversified portfolio then-is before diversification becomes a necessity. By the time the average investor “reacts” to the market, 90% of the damage is already done.
Modern Portfolio Theory
Modern Portfolio Theory (MPT) indicates that market timing and investment selection have minimal weighting in long-term investing success.
MPT further suggests that asset allocation strategies will prevail through the construction of an optimal portfolio by considering the relationship between risk and return.
The study of asset allocation (otherwise known as investment policy) states that asset mix determines 94% of the return of a portfolio-while less than 6% accounts from market timing or investment selection. (BHB Study, 1986)
Practicing consistent and on-going asset allocation is one of the most important habits for an investor to follow. Asset allocation involves dividing an investment portfolio among the three main asset classes-stocks, bonds, and cash. Liquid Alternative investments can be considered as a ‘fourth’ main asset class.
Risk tolerance is the foundation to developing your asset allocation strategy according to your financial goals and your feelings about risk.
Risk Tolerance indicates your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. Your selection of individual investments is secondary to the way you allocate your portfolio, which will be, perhaps, the principal determinant of your results.
Subtracting your “age from 100” to estimate how much of your portfolio should be invested in stocks can be a (very) rough estimate to consider. The asset allocation that works best for you at any given point in your life will depend primarily on your age, time horizon, financial objectives and your ability to tolerate risk.
An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment.
In the words of the famous saying, conservative investors keep a “bird in the hand,” while aggressive investors seek “two in the bush.” Investors who take on too much risk may panic and sell at the wrong time. You can access your degree of risk by taking one of a number of different risk tolerance questionnaires.
No investment strategy assures a profit or protects against a loss. Investing in mutual funds involves risk, including possible loss of principal.
Asset allocation does not ensure a profit or protect against a loss.
All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
*There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
“October. This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February.” -Mark Twain