Asset Allocation and Modern Portfolio Theory – why they don’t work very well.

According to Paul Merriman’s 40+ years worth of data (certainly, a lifetime of investing), being 100% in global stocks beat the pants off any combination of global stocks and bonds. More bonds in the portfolio resulted in lower returns and higher stocks resulted in higher returns.

No big surprises there as the history generally indicates the higher amount of stocks in a portfolio, the higher the return (over a long period of time).

The big surprise is that the 100% global stock portfolio completely crushed the U.S. stock S&P 500 Index which is comprised of 100% U.S. stocks.

If you are an investor whose objective is to make the maximum amount of money by investing in a basket of stocks, the question is moot. You are 100% invested, 100% of the time.

According to the Merriman data, the verdict is out – for maximum returns, you want 100% global stocks, 100% of the time. If you want lower returns with less fluctuation, then your portfolio might consist of a combination of stocks and bonds.

The best way to accomplish these goals is through the use of managed money (mutual funds) utilizing an adviser.

That sounds simple enough, until you read the headlines. The news media have no trouble whatsoever telling you when or what to buy, when to sell and that the coming Apocalypse is surely just around the corner.

Can you and your stomach tolerate the dizzying highs and the abyss-like depths of the stock market indices over a period of four or more decades?

If the answer is yes, hopefully, you are not going on this journey alone and will have a value and trusted adviser to keep you on the straight and narrow along the way.

The big debate with financial journalists is that the cost of the investments always trumps behavioral economics. Behavioral economics in a nutshell, is the study of what real investors do in the real world and what motivates investors to make rational or irrational decisions with respect to their investments.

Do-it-yourself proponents mostly dismiss investor behavior as either irrelevant or having little impact on returns. Cost to them is everything and advice costs money, so by avoiding advice, you will automatically save/earn fortunes.

Wrong. And here is why.

Investor behavior is emotion driven (we are humans after all) and our genetics never prepared us to make absolutely logical investment decisions during periods of extreme market crisis. Not helping things is the fact that people generally, are not that interested in financial things – except maybe, during a crisis. How about financial education and financial literacy courses? Will a financially literate investor become a better investor with superior returns? Although I would like to say yes, the researchers disagree. Financial education is a dismal failure, the experts say.

So, if clients in the real world don’t have much of an interest in financial things, and often succumb to buying at market peaks and selling at market lows, why do-it-yourself (DIY) proponents conclude that advisers cost too much money? Or, that behavioral economics somehow, does not apply to DIY investors. Or that DIY investors never actively mismanage their own passive investments?

It is true that no one admits they are just an average investor. A majority of investors believe that they are above-average investors just like they believe they are above-average drivers.

Certainly, all the empirical evidence (a couple decade’s worth) indicates that the average investor wildly underperforms their own investments by at least a few or sometimes several percentage points per year!

How is this even remotely possible? Surely, the evidence is not saying that investors do worse than their own investments?

Apparently, yes it does. As a result of a subset of repeating behavioral patterns, investors were making predictably irrational investment decisions at the most inopportune times. For instance, the inappropriate response to media reports was cited as one of the major factors causing underperformance.

It is difficult not to get too cynical here given the empirical evidence regarding the media. But the research infers that the media does not help investor returns at all, but play a very significant role in destroying them.

And for the ardent DIY financial journalists out there, the quantifiable massive underperformance were not due to MER costs, savings on advice, trailing fees or the other myriad of factors that these writers endlessly moan about. All of that pales in comparison to the far more important behavioral factors that have the ability to utterly destroy investor returns over a lifetime of investing.

Bottom line, the prime determinant of investor success is what they do with their investments after they bought them. In the real world, investors get investor returns, not investment returns – a very big distinction indeed.


This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see me for individual financial advice based on your personal circumstances. The opinions expressed are those of the author and not necessarily those of Assante Financial Management Ltd.

 
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