One of my good friends had recently gone skiing for the first time and was so drawn to it that he decided that he needed to purchase his own skis. He asked me to come along and off we went. It sounded like fun and since I was like most Cubans averse to any winter activity I thought it might be a pleasant way to spend an afternoon and maybe to learn a little. We went to various ski shops and at each one my friend asked questions that sounded very intelligent. He asked about the quality of the skis, the price of the skis, their versatility and performance characteristics. I couldn’t help but draw a parallel between how my friend, the ski novice, was shopping for skis the same way that people shop for investment advisors. By the time we went to the 3rd ski shop that day I was also becoming a bit of an educated consumer. The reality is neither my friend nor I knew anything about skis but we were learning the lingo. What happened at the 3rd shop and where he ultimately decided to buy was very different from the first two.
What happened? At the first two shops my friend asked questions that were answered technically or in a manner that described the features of the skis. Not once did the salesman at the first two describe the benefits of the equipment to my friend. At the third shop, a young salesman greeted my friend. Within seconds of meeting my friend he was able to determine that he was a novice skier and correctly assumed that my friend was interested in something other than equipment specs. Soon the salesman asked, what’s your favorite color? He didn’t wait for an answer he just went straight to “my favorite color is blue. Let me show you some blue skis. When we got over to the blue skis the salesman described the way he looked going down the mountain and how these skis were perfect for making him feel as though he was flying. He asked my friend how he wanted to feel going down the mountain and also asked him how he wanted to look. A few minutes later my friend walked out with blue skis. Blue was his favorite color as well. Many a portfolio is fashioned and many an investment advisor is hired in much the same way.
I will never forget this lesson since I and everyone I know makes many decisions this way. We look and purchase based on the perceived benefits because we are not expert enough to understand the features. In the case of a portfolio, we are not expert enough to understand the investment cycles or risks associated with a given portfolio. We make buying decisions based on how things make us feel or the way we may want to feel and not on reality. We are uneducated consumers and are easily deceived and most often by ourselves. Fortunately in the case of my friend the blue ski salesman correctly factored into the equation that my friend was a novice so he sold him some moderately priced skis that were blue but meant for a rookie. The salesman correctly matched the skis to the skier and made a sale. A year later my friend was hooked and was able to upgrade to a better type of blue skis and sure enough he went back to the same shop.
The portfolio decision is much more complex however, and if you buy or construct the wrong portfolio a year later you may be in deep regret. Many decisions are based on the perceived benefit to the buyer and not the features of the product. With portfolios you better understand the features. It’s especially important when hiring an investment advisor because they know so much more than you. They are at an advantage and a perfunctory interview won’t help you determine if they are right for you. Unfortunately, most people make their investment decisions the same way that my friend purchased his first pair of skis. They are irrational. They only think about the benefits but unlike the purchase of a simple pair of skis, this decision is far more important and has long lasting consequences. It’s in imperative that you don’t make rash decisions when it comes to your portfolio. You must know the specs.
We learned in An Asset Allocation Tale that asset allocation is simply putting different amounts of money into investments that have different characteristics. We have also learned throughout these tales that stocks outperform bonds and that bonds outperform cash. Let’s look at what the typical investor faces when determining their asset allocation and we will group the categories of bonds and cash into one category called bonds for the sake of this example. I call the types of portfolios that seasoned advisors or investment savvy investors create Behavioral Portfolios or BP’s. I call the types of portfolios that most investors create, Rational Portfolios or RP’s. What’s the difference between the two? The BP takes into consideration how most people behave with their money and the RP does not. The BP recognizes that people often act to their detriment; the RP does not. The BP takes into consideration that the actual client is an integral part of the portfolio while the RP does not. Let’s look at the following tables to see what I’m talking about.
Rational Portfolio Expected Rates of Return
Rational Portfolio Maximum Possible Loss
The above tables show what some might depict as the expected rate of return and maximum potential losses based on 11 different stock/bond allocations. The investor is then asked to choose a suitable asset allocation based on their risk threshold. People that have a 70% or higher allocation to stocks are classified as aggressive investors. Those with a 30% allocation or less to stocks as conservative and those in between as balanced. This cookie cutter depiction of the investor is not only how people classify themselves but also how most advisors classify their clients. This is the accepted wisdom but you can’t fall into this trap or you may be allocating your portfolio the way my friend purchased his skis. Why do I say this? Because the heroic assumption of an RP portfolio is that once a person sets sail on a particular portfolio composition they will follow the course until completion. This is a very bad assumption, proves wrong more often than not and can cost you a fortune. As an investor you must recognize that you have a variable risk profile. When things are going well you are happy. When things aren’t going well you are unhappy. Said another way, everyone wants to make 12% per year and in the worst case scenario lose no more than 10% when bad things happen. This is just unrealistic.
People change their risk profile all the time. The rational or traditional portfolio does not take into consideration the client. It does not take into consideration the Probability Of Maintaining or (POM) the original portfolio composition. What is the POM? The POM is a term I created and is a measure that most academicians recognize is absent from modern portfolio theory. I use it to factor in client behavior during periods of market disequilibrium. Disequilibrium is a fancy word for describing periods in the market where things are either going very well or very poorly. It is during these periods that people are most likely to alter their portfolio composition either out of fear or greed.
Let’s look at the following table to see some of my estimates of POM for the wealth building investor. Please recognize that this is not scientific. This is my best guess based on what I have seen over my lifetime. My experience indicates that a person that initially chooses a 100% allocation to stocks has a POM of less than 30%. This means that they have less than a 30% chance of maintaining 100% of their portfolio to stocks in their quest to build wealth. They typically change their allocation during periods where stocks are losing them a lot of money or during bear markets. Conversely, people that choose an initial 0% allocation to stocks also have less than a 30% chance of maintaining 0% of their money in stocks. They typically change their allocation during periods where stocks are doing great and they want to make some of the easy money they keep hearing or reading about. What I have found is that wealth-builders that are at neither extreme, those that are balanced in how they describe themselves, have a much higher POM or probability of maintaining their portfolio allocation. Interesting enough it also translates to better overall performance I have found.
Estimated POM over a Lifetime of Wealth Building
Let’s try to estimate how different the traditional model is from reality by taking client behavior into the equation. The formula I use is the traditional expected rate of return multiplied by the POM factor that I estimated plus or minus what the investors that alter their strategy make on their altered investments. I call the return that investors make on their money when they alter their strategy “The Great Unknown” or GU. The following table is what I believe is the “behavioral rate of return” that investors actually experience once you add their emotions to the equation.So why do I so strongly believe in the BP instead of the RP? Because once you introduce this new parameter, POM, the rational or traditional driven model falls apart. It becomes worthless. In fact, once you translate the effect of POM to performance you come up with an actual rate of return that is more apt to resemble what the average wealth building investor experiences and what most mutual fund investors actually experience. Morningstar Advisors even has a measure to track this observation that you can read about in A Tale of Hindsight. What I know is that the actual results of a RP will be completely different and in most cases significantly lower from what the traditional model would indicate because it doesn’t take POM into consideration.
As an example, if all the people that chose to build wealth by investing 100% of their money in stocks maintained their money in stocks their POM would be 1.0 instead of .3 and they would all make 12% per year because you multiply 12% by 1. We know this doesn’t happen so if you multiply my estimate of POM of .3 by 12% you get a 3.6% rate of return contribution from those that didn’t alter their portfolio composition plus or minus the performance of the 70% of the people from this category that altered their portfolio. We can see this result in the first row of the table below under the heading Aggressive. I have similar estimates for each of the 11 stock and bond combinations.
Observable Rate of Return
I think this tale explains why most wealth-builders are better served establishing a portfolio that is somewhere between 50% and 70% allocated to stocks because they are less apt to alter their portfolio at the wrong time. In fact most investors are better served with an allocation of 50%-70% throughout their lives but that is another tale. Investors are more apt to stay with a balanced strategy than one that is extreme. This 50%-70% allocation is a behavioral allocation and one that serves most people well. We know that stocks are the best way to build wealth and we recommend aggressive portfolios whenever we find individuals that we think are capable of maintaining their aggressiveness. However, during bad periods we must remind them of the future benefits to their aggressiveness.What can we conclude from the above table and the previous tables?
Can we make any sweeping generalizations about the rates of return that people make with their money during the periods where they alter their allocation? Can we infer anything from what I call the GU or Great Unknown? We can infer that there are two periods that capture the GU. In the first it is the rate of return that the investor experiences from the inception of their asset allocation to the day they switch. Let’s call this before switching period BS for “Before Switching”. Of course the second period that encompasses GU is the period After Switching or AS. So GU=BS+AS.
Let’s examine the GU of the three types of investors I’ve described, the aggressive, the balanced and the conservative. I’ve observed that the aggressive investor doesn’t get more aggressive. When they alter their strategy they are typically in a state of panic and become very conservative. They invariably fall under the behavioral trap without knowing it. They let fear motivate their actions. However, when they do panic at least their capital flight goes to conservative investments that pay guaranteed returns and thus their AS component is positive. However, their BS component is probably well below the 12% they expected and maybe even a negative return.
I’ve observed that the conservative investor doesn’t get more conservative. They can only get more aggressive. This person invariably chooses to alter their allocation near a market top. They see others making what they consider a quick or an easy buck and they want to do it themselves. They up their allocation to stocks at the wrong time, they enter near a market top and when they lose they get out. I expect that for these types of people their BS is positive but that their AS is almost always negative. Again these people have fallen under the behavior trap.
I suspect that the balanced investor when they do switch can either become more or less aggressive and it will be a function of their recent experience. However, because their POM is so high their GU isn’t as important as it is to the aggressive or conservative investor.
In summary, the balanced approach to a portfolio will over the long run produce better results for an individual because they can stay with it through thick and thin, or Bull and Bear markets. The fact is people will alter their investment strategy and it is up to the advisor to recognize this behavior tendency and make recommendations and build portfolios that are sustainable. It is up to the advisor to build Behavioral Portfolios and not Rational Portfolios. People want to buy blue skis, or Rational Portfolios because all they see are the benefits during the good times. All they see is the 12% rate of return. It is up to the good advisor, like the good ski salesman, to recognize this and give them the right kind of portfolios and skis.