Envy is a dangerous emotion and an infectious strain of it is oozing into the markets again.
I'm getting more calls from people who feel their portfolios just aren't keeping up. The main culprit tends to be their fixed income investments which are trailing equities. As a result, some investors are thinking about loading up on stocks. It's a dangerous idea.
Problem is, risk appetites are heavily pro-cyclical and they're driven by recent returns. When stocks climb, it doesn't take long for a bullish mood to prevail. On the other hand, declines inspire investors to dump anything with even a touch of risk.
Advisers use interviews and questionnaires to figure out an individual's tolerance, and capacity, to take on risk. But it's a tricky thing to pin down accurately.
On of my favourite risk questions concerns a game of chance that can be played only once. The question is, what is the most money you'd pay for a lotto ticket with a 50 per cent chance of winning $1,000 and a 50 per cent chance of winning nothing. (Post your answer in the comments section to see how you compare to other investors.)
The answers tend to be quite illuminating and are only rarely based on the mathematics involved. A few people are dead set against lotteries and wouldn't pay one cent for the chance to win $1,000. The majority usually opt for a number somewhat less than $500. A few gamblers might even be willing to pay more than $500 for such a ticket.
Generally speaking, lower figures point to a more conservative approach to risk taking and argue for holding more bonds and less stocks.
But such questions don't take into account the time varying nature of risk tolerance. To explore this thorny issue it helps to study past behaviour.
If you're an old-hand, think back to how you fared in past bull and bear markets. One doesn't need to go too far back because we've had some whoppers since the late 1990s. You should already know if you're a steady Eddie or if you suffer from the dreaded buy-high sell-low syndrome.
Morningstar studied overall investor behaviour in the U.S. by examining returns generated by mutual funds, and their investors, during the first decade of this century. They found that fund investors earned an average of 1.5 percentage points per year less than the funds themselves over the decade. They attributed the difference to poor timing by investors as they moved into and out of funds.
The bad timing drag is quite considerable. Even worse, many people fared much worse than average.
Regrettably, I've yet to find a surefire way to curb poor timing. After all, the ability to hold on through thick and thin largely depends on an investor's temperament. But there are a few techniques that might help.
One is to develop a long-term plan that is designed to work against the pro-cyclic pattern. The idea is to set a strategic asset mix that shouldn't be varied based on the market's moves. Instead, investors should rebalance regularly and thereby act in a counter-cyclical fashion. But buying low and selling high requires a great deal of discipline, both in good times and in bad.
The simple low-fee balanced fund can help in this regard. Not only do such funds rebalance their portfolios automatically, but they also shield investors from a great deal of the market's day-to-day volatility. They keep their holders focused on overall returns and not those of the stock markets which are more variable. On the downside, they do require sensible return expectations, which can be hard in bull markets.
I've become a fan of good low-fee balanced funds over time. They're well suited to novices and those who don't want to pay much attention to the markets. If you're looking for a few good managers, consider the low-fee offerings from Mawer, Steadyhand, and PH&N.
With the markets making new highs, I know the temptation to run headlong into stocks is strong. But it's far better to stick to a good long-term plan than it is to succumb to return envy.Report Typo/Error
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