Investors are well aware that financial markets go up and down. That is the essence of business and economic cycles. What is difficult for individual investors to master is how to act in the face of market advances and declines. Unfortunately, most people become very tolerant of risk and increase their exposure to the stock market when the market is advancing. Similarly, they avoid risk and clip their exposure to stocks when markets are declining, or after a large correction. It is human nature and “recency bias” that create this visceral response to market perturbations. Recency bias occurs when investors believe that the most recent performance of their investment portfolios will continue indefinitely in the future. It is just one factor that results in investors consistently underperforming the stock market.
Brad M. Barber and Terrance Odean, in their 2011 study “The Behavior of Individual Investors,” conclude that individuals routinely underperform benchmarks through 1) selling winning investments and holding losing investments, 2) being heavy influenced by most recent past returns (repeating investment behavior that coincides with pleasure and avoiding behavior that is painful), and 3) holding undiversified portfolios.
Dalbar studies have also shown that most individual investors typically trail the market rate of return, and they typically do so by a fairly wide margin.
The message from Dalbar since its first study in 1994 is that investment results are more dependent on investor behavior than fund performance and that mutual fund investors who tend to buy and hold are more successful than those who attempt to time the market.
Investors who attempt to time the market are often acting irrationally out of fear of a potential loss. Stocks and investment funds happen to be the only assets that people buy less of when they become less expensive. Let’s think about buying food at the supermarket, if the price of steak rose considerably, you would be more inclined to reduce your purchase of steak or buy something else, but if the supermarket suddenly reduced the price of the steak by 30%, you would stock up. However, you do the opposite when it comes to stocks and other investments. The stock market can foster a gambling mentality. When you are on a roll you hate to stop, but that is exactly when you should cash some chips in.
So how does an investor counteract the tendency to time the market and invest based on most recent results? Rebalancing is great way to fight the effects of recency bias. Rebalancing to your target asset allocation is a mechanistic and unemotional way to fight these counterintuitive emotions. I sometimes get an odd look from my clients when I suggest that they rebalance after a market run-up. “Why would I want to do that, the market is hot?” might be a typical comment. But that is exactly why rebalancing is so important. It removes the emotions, market noise, and other extraneous factors, and reminds the investor of their original financial plan and goals.
The best value-added proposition a financial advisor provides is to set the target allocation and then monitor and adjust it based on the client’s personal goals and life events. The asset allocation is set within the investment policy statement and the portfolio is rebalanced yearly, or as needed, after large market advances or declines. The asset allocation is revisited periodically, at least every 3 years, and is adjusted in response to a client’s retirement goals, change in health or marital status, or market valuations.
Rebalancing in this way, will not only help the client attain rates of return closer to the respective benchmarks for his or her portfolio, it can actually be a source of additional return. In a recent article in Financial Planning magazine, “Portfolio Rebalancing: Get It Right,” Allan Roth underscores the incremental benefit of rebalancing. His analysis shows that “over the past 15 years, the portfolio that stuck to its allocation earned 1.54 percentage points more each year than the average portfolio that tried to time asset classes.”
Rebalancing is just one area where advisors add incremental return and why it is essential for our clients to commit to the annual review and rebalance exercise. Emotions can be hard to control, let your re-balancing take them out of the mix, so you can maximize your long range returns.