New year, new strategy?
Alexander Joshi, London UK, Behavioural Finance Specialist
A new year may be a fresh start, but that doesn’t mean that your previous investment thesis is out of date. Periodically reviewing a portfolio is sensible, but so is making constrained and thoughtful changes for the long term.
New year, new me
This year may not have started as many would have liked, as COVID-19 spreads quickly through populations. The start of a new year is often a time of optimism, providing an opportunity to look at your life and build on the previous year. Finances and investments are naturally a key pillar of this review for many.
At the same time, investment houses regularly publish their outlooks and top investment ideas for the year ahead, which can give the impression that you should be re-positioning portfolios. The world does not, however, suddenly change when the clock strikes midnight on 1 January and render existing allocations out of date.
Review, but not too much
Periodic monitoring of portfolios can help identify potential investment risks or opportunities from likely longer term themes and ideas. Additionally, the market will always provide shorter term, tactical, opportunities should they appeal.
Making too many changes to a portfolio, however, can be detrimental. Market timing is extremely difficult. Furthermore, trading too much can introduce or exacerbate behavioural biases that can weigh on portfolio performance.
Beware of trading too much
People have a tendency to be overconfident about their own abilities. In investing behaviour, overconfidence has been shown to induce investors to trade excessively, to the detriment of returns.
Psychological research demonstrates that, in areas such as finance, men are more overconfident than women. Using account data for over 35,000 investors, men have been found to trade 45% more than women. Trading was found to reduce men’s net returns by 2.6 percentage points a year and by 1.7 percentage points for women. Transaction costs were not enough to explain the reduction.
The return patterns can be explained by factors such as difficulty in evaluating the many stocks available to buy, distraction by outside sources such as the financial media and selling far more previous winners than losers. Moreover, market timing is a significant challenge for all investors.
Problems of market timing
Trying to time the market can be risky. One reason people do this is explained by probability matching, in which subjects match the probability of their choices with the probability of reward when they vary.
Suppose one has to choose between two rewards: A that pays out on 70% of occasions, and B on 30%. The rational maximum-payoff strategy would be to follow the first option, which pays off seven times out of ten. The matching strategy consists of choosing A 70% of the time and B on 30% of occasions, which should pay out approximately six times out of ten (calculated as (0.7 x 0.7) + (0.3 x 0.3) = 0.58). The maximising strategy outperforms the matching strategy. However, most animals match probabilities.
When there is little chance of knowing the next result, the maximising strategy is the one that rewards most often. In terms of whether to stay invested or not on a monthly basis, historical data of investing in developed market equities suggests those that stay invested were rewarded approximately 60% of the time. Other strategies were unlikely to perform better.
A random walk?
A core-satellite strategy may be a prudent approach when making opportunistic plays to enhance returns alongside an existing core allocation
Financial markets are not entirely random. Indeed, there may be occasions when investing in or withdrawing from the market is justified. However, given how difficult timing is for even professional investors, it may be wise for short-term tactical tilting to represent a small proportion of a portfolio.
Large and frequent portfolio turnover is likely to underperform against staying the course with long-term investment trends. A core-satellite strategy may be a prudent approach when making opportunistic plays to enhance returns alongside an existing core allocation.
While individuals may be subject to behavioural biases, having a portfolio managed by a team of investment professionals following a robust investment process is likely to reduce the impact of individual biases. Following a thorough investment process usually further reduces the impact of group biases such as herding.
Investors paying for active management may, understandably, want to see their money being actively managed to justify the fees. However, investing success is not just about what an investor holds, but also what they do not hold. Not investing in a sector or company tends to be an active decision.
A quality active manager continually assesses the investment case for companies in and out of a portfolio. As such, low portfolio turnover is not necessarily bad. What is usually more important is the process, the buy and sell rules or discipline, and a long-term objective.
Actions you may want to consider
As part of an annual review, there are some actions which are often overlooked that investors may want to consider:
Rebalancing – As the values of some investments rise and others fall, portfolio allocations can stray away from planned and create unintended over or underweights. Small reallocations can be used to take profits and rebalance portfolios while staying invested.
Diversification and hedging – Investing does not have to be a binary, in or out, decision. Thoughtful diversification and hedging instruments can help to stay invested while maintaining discipline and lowering beta if required.
Cash – As well as reviewing allocations, you may want to take stock of cash positions. Holding cash may seem like a passive choice. It is actually an active decision to not be invested.
For investors retaining cash for tactical deployment, the longer it is kept on the sidelines, the stronger the case for having invested due to the opportunity cost of inflation. The potential returns forfeited from waiting for more attractive entry points can be significant. Phasing in investments may help nervous investors, but while this can provide a smoother ride, it typically comes at the cost of lower returns than if the cash was invested immediately.
When trying to meet long-term goals, getting and staying invested is likely to be the best course of action. The start of the year did not mark the end phase of the pandemic, as some hoped for. Such uncertainty might make it difficult to stay invested or put more cash to work. The start of the year is a good time to discuss such concerns with an advisor and put in place measures to allay concerns. Investing is like having a difficult conversation: it’s best not to hold off for another day.