Last week I received an intriguing comment from "Tom", a high net worth (HNW) investor in Montréal, who asked me some direct questions on the points I recently raised on asset allocation.
The questions led to a spirited (though good-natured) debate. I spoke to Tom and received his permission to reproduce a portion of his original email below:
"Why should I re-allocate? Especially right now? Why would I sell holdings I'm comfortable with and that I have done so well on? Why would I pay potential transaction fees and potential taxes to do so? Why would I turn my back on my buy-and-hold strategy, which has worked okay for me over the years? It just doesn't make sense to me."
I want to acknowledge that some of these comments are perfectly valid: particularly Tom's comment about fees, and about being comfortable with his investments. But as I explained to him, these aren't a rationale for putting your portfolio on auto-pilot. The analogy I would use is simple… in boating terms, we need to navigate our investments "looking forward over the bow", versus "looking back at our wake".
I pointed Tom to some insightful long-term financial research that explains how historically, re-allocating your portfolio every six- to- 12 months has been a good move, improving portfolio returns while minimizing tax frictional costs and keeping fees reasonable.
I also provided an example of how today's situation strongly suggests, for some investors, reducing government bonds at close to all-time highs (i.e., sell high), and rebalancing into global equities (i.e., buy low or decent valuations) and private equity positions (not exactly low, but definitely lower than bonds and reasonable valuations).
Tom and I ended our discussion on good terms. He thanked me for the information, and admitted the argument for re-allocating was rational. Still, I sensed there was a reluctance to take action.
That got me to thinking. If there's such strong academic and historic research to support re-allocating, and it also jibes with our financial common sense -- i.e., buy low, and sell high - then what exactly, still prevents us from doing it?
The answer: our emotions. Deeply-rooted, almost subconscious psychological reactions to financial events can sabotage our attempt to do the right thing for our portfolios. This is a particular issue that I see right now: investors understand the logic behind re-allocating, but they are emotionally unwilling to make changes. Given the volatility of the last decade, it's understandable that many investors are "stuck" or "frozen" currently.
Here are three of the common "reasons" I see why we don't re-allocate our portfolios. Hopefully, the more we understand these emotions, the better we'll be able to identify times when they are sabotaging our portfolios.
Change = pain
How often have you pounced on an investment, only to see it fall over the next month or two? It has happened to many of the HNW people I know. But it's the nature of the contrarian approach: if you're going to buy low, chances are your timing isn't going to be perfect. Out-of-favour assets can (and often do) fall further in the short term. Buying "high" is an even more painful experience however.
The problem is, our mind sees the paper/digital loss and starts to doubt. It's like the market providing a rebuttal to our investment intelligence. In the short term, rebalancing seems like the wrong thing to do - and we can see the proof in the stock price every day.
Naturally, this leads to reluctance to re-allocate the portfolio toward cheaper, beaten-up sectors and out-of-favour assets. Essentially, we are trying to avoid pain. While that helps us in the short term, it ends up costing us in the longer term.
The "wealth effect"
Instead of evaluating opportunities on their own, we often evaluate in the context of other financial events. When times are good, investors see the value of their portfolio go up. They may get a raise or a year-end bonus. They see their housing assessment increase. All this leads to a level of comfort with speculation and risk. They are more willing to take specific financial actions because they feel they can "afford" a loss.
Conversely, in times of uncertainty, investors see the stock market as volatile. They also see friends and family losing their jobs. They see cuts to bonuses, and "wage freezes." They see a lot of bad news headlines on TV and the internet.
The confluence of these events leads to a change in psychology, and a profound effect on one's willingness to re-allocate. We feel less willing to make changes, because it feels like we can't afford to take chances.
The blame or "regret" game
Everyone internalizes blame for bad investment decisions from time to time. ("What was I thinking?", "I can't believe I did that!", and so on.) But we also have help from others: spouses, bosses, business partners, clients. Explaining that you took on additional losses because you re-allocated the portfolio when the market was sinking can be a very hard thing to do - it often leads to a good deal of personal or professional stress.
I can tell you this happens to professional advisors as well. Handling others' hard earned monies has its challenges. Wealth advisors can and should be called to the carpet for underperformance over time, versus appropriate benchmarks. Portfolio managers can be fired, or have investors withdraw funds. As a result, many professionals also become more risk-averse after the market drops. They are less willing to accept short-term losses, because it is psychologically more stressful than "staying the course."
The solution to this problem: make re-allocating automatic. By systematically re-balancing your portfolio every six- to- 12 months (five- to- ten minor adjustments, or five- to- 20 per cent in aggregate per year, are usually all that's necessary) you minimize the possibility of emotions derailing sound financial decisions. No, it's not easy to do. But it almost certainly will help improve returns and reduce risk over time. There's a reason why the "top three per cent" of households control over 80 per cent of the wealth. They have learned to master their emotions and go against the crowd.
Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as portfolio manager and director, wealth management. Thane is also Managing Director forTIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)'. www.stennerinvestmentpartners.com (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.