A lot of time, energy and money are wasted seeking alpha – trying to beat the averages. This may be heresy to you, but before you get mad, or stop reading, let’s have a discussion. You may find that there are better ways to spend your time, energy and money
What works? What doesn’t work?
Most investors know what works and doesn’t work, but their behavior would suggest otherwise. Asset allocation works, It explains 100% of investment performance – yes, all of it. Accordingly, most of our time, energy and money should be spent on asset allocation.
A plan for asset allocation is called an investment policy. Deviations from policy are intended to add value, namely alpha, but these attempts are well documented to actually subtract value.
The classic Determinants of Investment Performance is frequently cited for discovering that investment policy explains more than 95% of investment performance, but this study has been misinterpreted and understates the importance of policy. An updated report entitled the Importance of Investment Policy corrects the analysis and finds that 100% of performance is explained by policy.
This updated report finds that stock selection and market timing subtract value, but there is some slight evidence that concentration (big bets) can pay off. This finding was published long before the introduction of the so-called “Active Share.” In other words, big bets can pay off, but of course, big bad bets can be very costly.
Let’s focus on what works, and how to make the best decisions about asset allocation.
Smart asset allocation
Asset allocation is established to achieve objectives with a reasonable likelihood. Allocations are adjusted in response to successes and failures in this achievement. Plus goals change through time. It’s dynamic and challenging.
Asset allocation decisions are risk decisions. We need to take a certain amount of investment risk to earn the return we need. This risk decision is called “risk willingness.” The risk willingness decision needs to be conditioned on two more decisions:
- Do I have the risk capacity for this level of risk?
- What is the smartest way to take this risk?
There are circumstances when investors simply should not take the risk it requires to achieve their objectives because they don’t have the risk capacity. Specifically, there comes a time in everyone’s life when risk capacity is very low because the stakes are as high as they will ever be. We cannot afford to lose money at this critical time in our life, warranting its title as the “Risk Zone” that spans the 5-10 years before and after retirement. Losses in the Risk Zone can devastate retirement lifestyle and reduce the length of time that savings last, even if markets subsequently recover. Even the very wealthy should protect themselves in the Risk Zone because they too have plans that can be ruined.
Smart asset allocation is tailored to achieve our goals, unless we cannot tolerate the requisite risk, especially in the Risk Zone
As for the second condition, the smartest way to take risk is to be as diversified as you can be. Diversification provides the best returns for the risk over time.
Why investors pursue what doesn’t work
Author Jonathan Clements describes this behavioral problem very well in his Bullheaded article. Here are some excerpts:
If beating the market is a game that we’re extraordinarily unlikely to win, why do so many folks keep trying? Market-beating efforts may backfire for most investors, but they remain a huge moneymaker for Wall Street. What else can explain the hysteria and silly arguments constantly emanating from investment “professionals”? These folks have all but given up
Investors’ overconfidence is also fueled by a host of behavioral mistakes. We often imagine we see patterns in today’s share price movements and believe those patterns foretell what’s to come. Looking back, what occurred in the markets seems obvious—and we may even feel we predicted what happened, a mental mistake known as hindsight bias. But perhaps the most insidious behavioral error is availability bias. Every year, most stocks underperform the stock market averages, because the averages are skewed higher by a minority of stocks with huge gains. Yet it’s those big winners that stick in our minds, and they make beating the market seem easy. What if we try our hand at finding the next hot stocks? The odds suggest we’ll end up picking duds instead—and our results will lag behind the market averages.
Many smart people have advised against trying to pick better stocks and against trying to call market turns, like John Bogle, founder of Vanguard, and Nobel prize winner Dr. William F. Sharpe, but few have said it better than David Loeper, founder of Wealthcare advisors, in this interview:
It is about avoiding needless sacrifice of your life. It is about unquestionable moral integrity. It is about using one's mind to create value. It is about the profound value of an individual's life and making the most of it. Our patented Wealthcare advising process applies these Objectivist premises, and this results in extraordinary value in our advice to clients. That's the process that I invented.
The process Mr. Loeper refers to is described here. In a nutshell, it’s a “Keep your eyes on the prize” process focused on establishing and achieving goals through the combination of intention and attention. Importantly, the process guards against useless distractions like stock picking and market timing.
The smartest investors spend their time, energy and money wisely by focusing on what matters most, namely asset allocation/investment policy. Getting this critical decision right is not that easy. Attempts to improve performance results typically fail and take our eyes off the prize, namely achieving our goals.