Published by Jake Bleicher and the our firm Investment Committee
A strategic wealth management plan often focuses on investment allocation. Empirical evidence suggests that asset allocation explains 91.5% of return variation over time (Brinson, Singer & Beebower 1991). By that logic, investors and advisors are correct in making the decision paramount. However, such a myopic view of the individual omits very real considerations. Incorporating behavioral finance into traditional strategic portfolio planning can help avoid costly emotional errors, which arguably are the biggest detractor to investment returns.
Traditional financial theory assumes all investors rationally process ALL information and make unbiased invest decisions. Thus, a strategic wealth plan is simply an optimized allocation to assets that pursue an investor’s return requirements while minimizing risk. Psychologists disagree; human beings are not always perfectly rational. Decisions often reflect emotional and cognitive biases. Even the most stoic investors cannot possibly process ALL available information, it would be impossible. Rather, they make sub-optimal but adequate decisions. Moreover, a majority of investors (aka human beings) are emotional. If they weren’t, the tech bubble at the turn of the century and the real estate bubble in 2007 would have never occurred. This is not a modern finance phenomenon; the tulip mania in 1637 predated Adam Smith by nearly a century. A perfectly rational investor would avoid such overpriced assets. The average equity investor underperformed the S&P 500 by 4.66% over a 20-year annualized horizon, predominately due to emotional biases (Dalbar 2015*). Certainly allocation is important, but 4.66% compounded over long periods of time amounts to an enormous shortfall. To be successful, investors and advisors must consider human nature a paramount risk when developing a strategic wealth plan.
A simple approach is to combine our innate desire to segment assets into different buckets with traditional asset allocation. Financial theory argues that mental accounting leads to sub-optimal investment allocations, ignoring correlations between asset classes and the fungibility of money. Who doesn’t consider an emergency fund as distinctly separate from a checking account or a 401K? It’s human nature. Rather than attempt to perfectly optimize the entire portfolio, allowing investors to create different “buckets” clearly defines which account is meant to meet each goal. After all, is a 401K not for retirement and an emergency fund, but for an emergency? This simplifies allocation decisions and helps prevent decisions made out of fear. Investors, and advisors, are more likely to stay the course if there is a clearly defined process.
While asset allocation, in theory, may predict 91.5% of expect returns, emotional errors tend to be the most damaging in reality. When developing a strategic portfolio management plan, clearly define which assets are meant to fund future goals. Having a conservative bucket to meet basic needs will reduce the likelihood of a damaging fire sale in the more aggressive aspirations bucket.
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Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. No strategy assures success or protects against loss.
*DALBAR’S 2015 Quantitative Analysis of Investor Behavior (QAIB) study examines real investor returns from equity, fixed income and money market mutual funds from January 1984 through December 2014. The study was originally conducted by DALBAR, Inc. in 1994 and was the first to investigate how mutual fund investors’ behavior affects the returns they actually earn. In 2014, the 20-year annualized S&P return was 9.85% while the 20-year annualized return for the average equity mutual fund investor was only 5.19%, a gap of 4.66%. 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.