Asset Allocation Basics Podcast
Are your assets where they should be? Learn how to determine asset allocation that’s right for you.
Podcast Transcript Episode 8
Doug Fabian: What is your asset allocation? And why should you care? Have you ever been the victim of bad investment behavior? Asset allocation and investor behavior go hand in hand. Learn why these actions matter to your investment returns in this episode of the Science of Economic Freedom.
Man: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment perspectives carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors and is not involved with investment services.
Doug Fabian: Welcome to the Science of Economic Freedom. I’m your host, Doug Fabian. This podcast is all about helping you achieve your financial dreams. We call that economic freedom. This program is about your journey to achieve economic freedom for yourself and your loved ones.
Today, we want to help you identify your next step on that journey. This is episode 8, asset allocation and investor behavior.
The first 11 episodes of the science of economic freedom are our foundational material. If you’re new to the podcast or just getting started on your journey to economic freedom, we strongly suggest reviewing all 11 episodes in order. This will give you the foundation you need to fully understand the process and the factors to achieving this goal.
Why is asset allocation so important
Today’s subject is about allocating your investments and keeping your emotions under control when volatility shows up in the financial markets. These will be important lessons to your success. Asset allocation is the single most important decision you will make when investing your capital. Let me say that again. Asset allocation is the single most important decision you will make when investing your capital. This statement is based in science.
There have been many studies confirming this fact and documenting the value of asset allocation on long term investment performance. The first study was conducted in 1986, looking at 91 pension plans in the United States from 1973 to 1984. This study concluded that what mattered most to the performance of these pension plans was the manager’s allocation to asset classes. It was further determined in this study that market timing and security selection did little to increase the total return of the investment portfolio.
There have been numerous studies since then that have confirmed this fact that asset allocation is the single most important contributing factor to your long term investment results. Science is at the foundation of asset allocation. How you choose to invest across asset classes will determine your success over your lifetime.
It is also a well-documented fact that investor behavior has significant influence over your results. This means that if you change your asset allocation in the short term due to market conditions, it will hurt your long term results. We will talk about those studies and results later in the podcast.
What does asset allocation mean?
Let’s begin with what asset allocation means. Asset allocation is proportioning your portfolio among investment assets to maximize return at a given risk level. To put this simply, you need to determine how much of your portfolio you’ll be investing in stocks, bonds, and cash. Originally, asset allocation included just three asset classes. Today, investors have many more choices and subsets of these basic categories, but the concept is the same risk versus reward.
We have talked about these asset classes, stocks and bonds, but there are others as well. Here is Don Calcagni’s discussion about asset allocation and asset classes.
Don Calcagni: Asset allocation is a decision that investors make with respect to what assets they decide to own in their portfolio. Even an investor that’s 100% in cash by definition has an asset allocation, they have chosen to own 100% cash. In modern terms, asset allocation means owning more than just cash. It’s owning stocks, bonds, real estate, commodities, variety of different investment assets that behave differently during different phases of the economic cycle.
Broad asset classes in the context of explaining asset allocation
Doug Fabian: How would you describe the broad asset classes in the context of explaining asset allocation?
Don Calcagni: So, when I think about asset classes, I always think about a very basic question. You can either be a lender or an owner when it comes to investing your capital. As a lender, you’re actually purchasing bonds, for example. So, you can lend money to a corporation or a government or even specific projects, turnpike projects, for example. In return, you are paid a fixed interest rate generally to compensate the investor for lending capital to a company.
You could also be an owner. You can own stock in a company and what that means is you then have a claim on all of the assets that the company owns. And you have a claim on the earnings that that company generates. So, you can fundamentally be an owner or a lender. And I think that’s the first thing that investors have to be aware of when you’re thinking about asset classes.
And then you can be an owner and a lender anywhere on planet earth these days, right? You can purchase Chinese stocks. You could purchase Australian bonds. There’s really an unlimited number of different asset classes that investors can really execute that decision to be an owner or a lender.
How would you describe the category of alternatives or commodities in the asset allocation discussion?
Doug Fabian: How would you describe the category of alternatives or commodities in the asset allocation discussion?
Don Calcagni: Yeah, that’s a great question. So, I’ll begin with commodities and then we’ll tackle alternatives. When I look at commodities, you’re really making a decision to own, right? So, you’re not lending to a commodity. You’re buying gold or you’re not buying gold. So, owning commodities is really sort of that ownership decision. Commodities could be part of an asset allocation.
I think it’s important when we’re thinking about commodities to understand that they only have value to the extent that an enterprise either a government or a company takes that commodity and transforms it into a product for sale, right? Owning a bar of gold by itself does you absolutely nothing. You can’t go to the McDonald’s drive thru, chip off a piece and buy a Big Mac. They’re not going to let you do that. But that said, commodities could play a very important diversification role within a global portfolio.
With respect to alternative investments, alternatives are really just a buzzword. So, we got to be really careful when we start thinking about alternatives. Academics or professionals who practice in that space have very specific definitions for what constitutes alternatives.
At Mercer Advisors, an alternative investment is something that is very different from a traditional stock or a bond allocation. It is something that takes what we call both long and short positions in stocks and bonds. And what that means in layman’s terms is they both own and sell the same thing at the same time.
And I know that that could really wrap a lot of folk’s brains in a knot. But fundamentally, that’s what’s occurring. And what the outcome is is investors have very different risk and return experiences with alternatives than they do traditional stocks and bonds.
Asset allocation vs. diversification
Doug Fabian: Asset allocation is different than diversification. Diversification refers to the number of securities you may own in a single asset class. For example, looking at the stock portion of your portfolio, owning many stocks of both large and small companies would constitute diversification of the stock segment of your portfolio. Here is Don Calcagni on how asset allocation differs from diversification.
Don Calcagni: So, an investor theoretically could have a one asset portfolio. Let’s say they own US large cap stocks. That’s one asset class. I would argue that from an asset class perspective, it’s not diversified. But you can own 100 large cap US stocks and you could be diversified within the asset class. So, when you think of diversification, that really just means owning many, owning a lot of something.
So, we want to diversify both at an asset class level. We want to own US stocks and non-US stocks, emerging market stocks. We also want to own bonds or real estate. So, you want to diversify across asset classes. But then equally important is you want to diversify within each of those asset classes and own more than just one piece of real estate. Let’s own 400 pieces of real estate through a diversified real estate investment strategy.
Why does asset allocation matter so much?
Doug Fabian: As we mentioned in our last episode, as an investor, you’re in complete control of the number of securities you own and your asset allocation. These are two elements that you must know, understand, and implement. Why does asset allocation matter so much? It is the single most important determining factor of your investment performance and its influence of the amount of risk that you’re exposing your portfolio to.
How so? A 100% stock portfolio has a higher level of risk than a 100% bond portfolio. The allocation with the least risk would be cash, but cash does not provide a return above inflation. Stocks can give you the highest long term return but subjects you to the most short term risk.
So, what is investment risk? The chance that an investment’s actual returns will be different than expected. Risk includes the possibility of losing some or all of your money. Having an investment portfolio that is exposed to multiple asset classes reduces risks and smooths out volatility.
How do you implement asset allocation?
Here is how you implement asset allocation. Before you invest, you decide on your risk exposure. How much of your portfolio do you want to expose to higher risk assets? Once you have determined this percentage, then you can decide your exposure to other asset classes like bonds, real estate, and cash. All asset allocation decisions are stated in percentage terms.
Best practice for asset allocation
Now, there are best practices when it comes to asset allocation, keeping things simple. Once you’ve decided on your asset allocation, do not change it on the short term. There are maintenance issues with asset allocation. For example, after an asset class has experienced a good or a bad year, portfolios may need to be rebalanced if your asset allocation has moved out of your preferred zone. What are typical asset allocation mistakes? Making short term changes based on news, feelings, or outside influences.
What is investor behavior
This brings us to our second subject today, investor behavior. Investor behavior means frequent changes, adjustments, or tinkering with your portfolio. There’s a great quote from Warren Buffett on his investment style. Here it is. “Lethargy bordering on sloth remains the cornerstone of our investment style.” This means he rarely, if ever, makes a change to his investment strategy once his allocation and diversification are set. This will be your biggest challenge. Here is what Don Calcagni has to say about investor behavior.
System one and system two thinking
Don Calcagni: Investor behavior is really a word that investors begin to interfere, if you will, with the investment process. That’s where we make a decision to buy or sell something or we’re changing maybe the weights of a specific allocation. And the first thing I think that’s important to understand when it comes to investor behavior is what psychologists refer to as system one and system two thinking. The brain functions in two very different ways.
System one thinking is, as a species when we have a visceral, emotional, immediate reaction to a certain stimulus, right? We opened our investment statement, we’re down 20%. And there’s this visceral response where we just want to head for the exits, call our advisor and sell everything under the sun. That behavior is typically very damaging, very detrimental to investor’s long term investment returns. And there’s a significant body of literature, a significant amount of research that shows that investors who respond in that way with that system one type thinking that it significantly erodes their returns quite dramatically.
System two thinking is where the more rational side of the brain kicks in. It’s where we put a little bit of distance between stimulus and response. And we interfere with that visceral immediate reaction that we have as a species. System two thinking allows us to slow things down just a little bit and to analyze the situation. We are a highly intelligent species. We have large brains for a mammal of our size. And so, by just doing that, by just slowing things down and engaging system two thinking, that’s where investors can respond a bit more rationally to the stimulus in the surrounding environment. When we do that, we have substantially better investment outcomes for investors.
The reality of it and studies to prove it
Doug Fabian: Now, here’s the reality of it. When the stock market is up, you will want to own more stocks and believe that stocks will never go down. When the stock market is down, you will believe that stocks will never stop going down and you will want to get out of the stock market. When you hear from a friend about a great investment that they have made, you will want to participate. Now, this is not our opinion. The scientific evidence is overwhelming when it comes to investor behavior.
Investment behavior has been studied and examined from a scientific point of view. Here’s a direct quote from the findings of the Barber-Terrance Behavior of Individual Investors Study in 2010. In practice, investors behave differently. They trade frequently and have perverse stock selection ability, incurring unnecessary investment costs and return losses. They tend to sell their winners and hold their losers, generating unnecessary tax liabilities. Many hold poorly diversified portfolios, resulting in unnecessarily high levels of diversifiable risk and many are unduly influenced by the media and their past experiences. Individual investors who ignore the prescriptive advice to buy and hold low-fee well-diversified portfolios generally do so to their detriment.
Continuing from the study, here are the reasons investors underperform. High portfolio turnover, asymmetric information. They don’t have the information they think they have and are susceptible to confirmation bias. This means their research confirms their conclusions. Investors are overconfident. They believe too strongly in their abilities. Many are sensation seekers. They love the thrill of investing. Others invest in what is familiar to them. They sell winners and hold losers. They cause taxable events that are unnecessary. And they are unduly influenced by the media.
There’s another study that has been renewed and revisited every year focused on how mutual fund investors perform versus mutual fund portfolios. The DALBAR study examines the performance statistics of individuals and mutual funds and examines the results of their buying and selling. The study has been conducted every year since 1994, 23 years. The conclusions are stunning. Individual investors hurt their long term returns every year since the study began. Buying and selling hurts average investor’s returns every year.
Looking over the 20-year data period from 1996 to 2015, the average investor’s returns were only 2.1% versus 8.2% annualized for the S&P 500. That’s more than 6% per year lost in attempts to beat the market. There’s one more factor that comes into play with investor behavior. We call it the greed-fear cycle. This is based on how investor confidence swings during bull and bear markets. To say it simply, there is a greed at market tops and there is fear at market bottoms. This is also proven when looking at the flow of money statistics. Investors rush into stocks in greater mass after the market has had a significant up move. And investors pull out of stocks at/or near the end of a market decline.
Now, the conclusions are obvious. Do your homework ahead of time, know yourself and your risk level. Set your asset allocation according to your personal comfort level and time horizon. Once you’ve set your asset allocation, don’t touch it unless there has been a significant life changing event such as retirement. Rebalancing should be followed on a quarterly or a semi-annual basis.
So, let’s summarize this episode. Your asset allocation is the single most important influencing factor when it comes to your long term investment performance. You’re in complete control of your asset allocation. Your asset allocation controls your risk and reward. Too much risk can cause you to panic during market declines. Bad behavior can be caused by many factors such as the media, what you’ve heard or read, or how much market volatility there is. When you’re inclined to sell, check back in with your long term goals.
Now, here are the action steps from this episode. Find out what your current asset allocation is. Look at your 401K or other investments. How much do you have exposed to stocks, bonds, cash, and other asset classes? Second, discover your optimal asset allocation. This can happen with a discussion with your investment advisor or even your spouse.
Lastly, examine your investment history and answer this question, have you ever made an investment decision or change due to emotions? Last step, send me an email. Send me your questions, show topics, and ideas to [email protected]. This is Doug Fabian. Thanks so much for listening. [Music]
Man: The Science of Economic Freedom is intended as an investor education resource. The views and opinions expressed on this program should not be construed as a recommendation to buy, sell, or hold any specific security. Consult your investment advisor and read any investment prospectus carefully before making any changes to your investment portfolio.
This program is sponsored by Mercer Advisors. Mercer Global Advisors Inc is registered with the Securities and Exchange Commission and delivers all investment related services. Mercer Advisors Inc is the parent company of Mercer Global Advisors Inc and is not involved with investment services.