As you know, I love mocking people who believe that we are “rational” and “logical.” These tend to be economists, engineers, and other people who are clueless about human behavior.
One of the best ways to reveal the difference between what rational people “should” do and what real people actually do is to talk about rebalancing and asset allocation.
Today, I want to demystify what most people think determines investor success…versus what actually matters.
* * *
The reasons for investment success are not obvious. Most people mistakenly believe that your stock choices determine your success. In reality, you shouldn’t even be picking individual stocks (though this is what men in their 40s talk about at parties…that and traffic routes). Others believe that timing the market works, which is false.
In reality, one of the most important parts of investing — perhaps THE most important part, besides starting early — is your asset allocation. This is basically the way you’ve laid out the pie chart of your portfolio: How much do you have in equities (stocks)? How much in bonds? And how does it change over time?
Are you in your mid-20s? Here’s a sample asset allocation for you
Look at that chart. Again, most people mistakenly believe that “investing=picking stocks” and therefore they need to worry about which stocks to buy, when in reality the actual equities (stocks) you choose are far less important than your overall asset allocation. In other word, your pie chart matters more than the actual ingredients.
Ok, so the person in the above example is 25. Under which conditions would the pie chart change?
It turns out this is one of the most important questions investors can ask themselves.
What is rebalancing?
Over time, your asset allocation will change, and so will your needs. For example, let’s say the stock market climbs for a 10-year period. You may have far more stocks than your pie chart calls for, so you’ll want to adjust back down.
Alternatively, your needs will also change: When you’re 25, you have a long time before you need your long-term investment money. Therefore, you’re risk-seeking: You have a large appetite for risk because you want higher potential rewards.
At 45, you’ll want to become more conservative and protect what you’ve acquired. You can’t afford the same risk as a 25-year old.
At 65, you are simply waiting for your inevitable death, so you become correspondingly more conservative.
I wrote about this more eloquently in my book, so here’s an excerpt. And yes, I find it remarkably fulfilling to quote myself:
How do you do that?
Who wants to monitor that?
Asset allocation and rebalancing are hard
Asset allocation is complicated. The best institutional investors in the world — like investment managers at university endowments — are hyper-focused on deciding whether they should have 13.1% or 13.3% of timber, or venture capital, or hedge funds, in their portfolios.
But asset allocation is complicated for individual investors, too — though not for the reasons you think. Since individual investors don’t have access to sophisticated alternative investments, we essentially have to decide among 3 areas of investment: Equities (stocks), fixed-income (bonds), and cash. 3 choices. On the surface, it doesn’t seem too difficult.
But over time, it becomes profoundly difficult to maintain the “right” asset allocation. Why? The reason may surprise you.
The Looming Enemy: Why you don’t rebalance
We now know that asset allocation is one of the most important factors in investing success. So why do we find it so difficult to maintain a reasonable asset allocation? Why do you find grandmas with 90% in stocks, while you also find 25-year-olds with 30% in bonds?
Since we’re wading into fairly advanced investing strategy, you might think that the primary reason is that people don’t know about complex mathematical models or fail to understand some deep nuances of investing.
The primary reason we fail to maintain a reasonable asset allocation is human psychology. We are subject to many powerful psychological biases when it comes to investing (more about the psychology of money).
Even if we have a helpful chart like this…
…we still fail to maintain a reasonable asset allocation over time.
“This analysis assumes that for all of these portfolios, investors kept their money in the funds through the hair-raising markets of 2001 and 2002 and rebalanced the portfolios annually, returning them to their original allocation. But such disciplined rebalancing can be a tough sell, said Hersh M. Shefrin, a professor of behavioral finance at Santa Clara University in California. “We are pleasure-seeking beings who want to avoid pain,” Professor Shefrin said.
Rebalancing, he said, would have forced investors to do exactly the opposite — by making them either prune assets that had done extremely well, or to load up on assets that had disappointed them.” (via NYT)
To put a finer point on it, from a nice article in the Canadian Business Online blog:
“When stocks were crashing in late 2008 and early 2009, did you rebalance your investments? Did you actually move money out of cash and bonds into stocks?
Many did not. They either froze or dumped stocks in a panic. At least that is the conclusion of a recent study released by two finance professors, Louis H. Ederington and Evgenia V. Golubeva, at the University of Oklahoma.”
Let’s get to the nitty-gritty of what you need to know.
What you need to know about asset allocation and rebalancing
- Asset allocation is the #1 or #2 most important thing you can control when it comes to investing
- Contrary to what most people think (especially technical people), the difficulty in maintaining asset allocation is not technical skill. It is investor psychology. You will inevitably think you can out-think the market. You will fall prey to several investor biases. You will not be disciplined enough to rebalance on a regular basis. You are human. “Trying harder” in this area doesn’t work for 99% of people.
- Forget picking stocks, since investing is not about picking stocks. Again, investing is not about picking stocks. Most individual investors shouldn’t even pick one stock. Instead, they should use target-date funds (aka lifecycle funds), which choose an asset allocation based on your age and automatically rebalance for you over time.
- The media does not like to write about asset allocation because it’s complicated, scary, and you can’t easily put a picture of a guy standing in a suit with his arms crossed talking about how asset allocation helped him pay off his debt and send his kids to college. Jesus christ I am getting angry writing this
- Most people don’t even know what asset allocation is. But even those who do fail to rebalance their portfolios in a disciplined way. This is true even of professional portfolio managers!
- The best solution is to automate this process by investing in a target-date fund (aka lifecycle fund). Those funds automatically rebalance for you. And for each person who debates minutiae about the minor percentages they disagree with (“it should be 16% large-cap, not 14%!!!”), 1000x more people are helped by the automation of regular rebalancing.
Investing without an asset-allocation plan is like riding a tricycle in South Central LA, naked, blindfolded, wearing a large fanny pack full of $20 bills. It doesn’t matter how disciplined you “think” you are going to be in steering straight and true. You are still going to get your ass beat.
Most investors don’t even have a plan for their asset allocation. They simply invest randomly here or there, picking a fund or stock that catches their fancy. 40 years later, they complain about the government, taxes, and the media for their poor investing returns. (They’re not the only ones to blame, of course.)
But perhaps even more pernicious are the people who are well-read about investing — but then decide they want more “control” so they’ll manually adjust their asset allocation. This may work when they initially start investing and are highly motivated, but over time, they — like everyone else — fall prey to natural human biases and weaknesses, leaving them with an exposed asset allocation. Perhaps 1% of investors can maintain the discipline to maintain an appropriate allocation over time.
Chances are, you can’t.
I know I can’t. And that is why I use target-date funds.
Bottom line: You are human. No matter how motivated you are about investing right now, you will find other things more urgent and important later. We are all cognitive misers with limited cognition and willpower. Investing in a target-date fund lets you compensate for your natural weaknesses and biases by automating complex asset-allocation decisions.
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