When meeting with prospective clients, I will ask what they think their current asset allocation (percentage in stocks, bonds, cash) is for their investment portfolio. If they don’t know, and they often don’t, I ask what they think, given their circumstances, a reasonable allocation would be. Typically their answer and their actual asset allocation bear little resemblance. Why does this matter? Simply put, properly constructed asset allocation frameworks are critical to long-term investment success. Study after study illustrates that asset allocation accounts for over 90% of total portfolio returns, with security selection and market timing comprising the balance. Determining your optimal long-term asset allocation is the central task for any investor, and yet few devote careful consideration to it. By not doing so, an investor is much more likely to get caught up in the rising and falling tides of conventional wisdom and his own psychology, which leads inevitably to behaviors which damage long-term investment success and financial health.
A look at the last twenty years highlights the ever changing tides on Wall Street, and how many investors are damaged by them. This period has produces three large bull markets, and two pronounced bear markets. The late 1990s saw investors pile into very highly-valued, surging technology and growth stocks, and piling out of cheaply-valued old economy value stocks. Passive investing was also en vogue, at the expense of underperforming active managers. One final trend saw US stocks far outpacing the performance of international stocks. When these elongated trends are in place, they are self-reinforcing, picking up more and more believers, which propels assets ever further, which then begets even more consensus and asset flows. In bull markets, this process continues until the ultimate peak, when by definition the maximum amount of capital is invested in assets with the maximum degree of risk. When the tide turns, the unwinding of these trends is often violent. Following the 1999 peak, value stocks dominated growth and tech, active management dominated passive index investing, and international stocks dominated US stocks for nearly a decade. The trend reversed once again just after the financial crisis, with growth and tech, passive investing, and US equities outperforming to this day.
I contend that most individuals and households have no real allocation framework and tend to pay only cursory attention to their portfolios while markets are calm. The amount of attention increases dramatically, however, in times of market excess. It’s typically only in a severe bear market that an investor thinks seriously about risk, which leads to a strong desire to reduce the allocation to equities. Alternately, in a long-building and later-stage bull market investors feel the drag of cash in their portfolios and feel compelled to increase equity exposure and reach for return. As humans we are hardwired to seek comfort and consensus, and the consensus is never more compelling and persuasive than when it is nearing a crescendo.
A couple actual examples of investor allocation behavior illustrates this phenomenon. Since 1995, the cash allocation for all of Charles Schwab customers has averaged 16%, with three instances of peak cash allocations (20-23.5% cash), and three instances of trough allocations (11-13.5% cash). High cash allocations signify investor caution and low enthusiasm for stocks, and yet the times when Schwab customers had the most cash (1996, 2002, 2009) occurred right before equities went on to post superb forward performance. The average compound annual return for equities in the subsequent 5 year period following these periods was a robust 23%. How about when Schwab clients had the lowest cash allocations, when they were the most enthusiastic about stocks (2000, 2007, 2017)? Unfortunately, this bullish allocation shift was as poorly timed as the bearish one. While it is too soon to say what will happen post 2017, the average compound annual return for equities in the 5 years following 2000 and 2007 was 0%.
In a similar vein, BofA Merrill Lynch data shows that its wealth management clients had peak equity allocations of 56% in the spring of 2007 roughly six months ahead of the market peak. As the financial crisis intensified in 2008 and 2009, client equity allocations fell to a trough of 39% in February 2009, nearly concurrent with the bear market low. Once again, investors had peak exposure to equities at the time of highest risk, and trough exposure when equities offered the most reward.
What’s the answer? In my estimation, the solution is to build proactive investment safeguards to prevent a client from falling prey to this reactive self-sabotage. The key is to work with an advisor who understand these psychological pitfalls, and has the tools to equip you with a battle plan to avoid them. It is imperative for the client and the advisor to spend considerable time collaboratively crafting a well-articulated and individualized asset allocation framework that fits the client’s unique financial picture and internal psychological wiring. It is critical for the client to buy into the allocation, and be willing to stick with it, particularly when it is out of step with market conditons. The client must both intellectually understand the rationale behind the framework and also be psychologically committed to adhering to it-particularly when it feels wrong. In a bear market, the allocation framework will dictate trimming outperforming cash and bonds and adding falling stocks. Conversely, in elongated euphoric bull markets, the process entails trimming equities and adding to cash and bonds.
Working with an advisor who will construct a personalized allocation framework with you and will keep you on that path, particularly when your emotions are telling you to do the opposite, is an important component of building long-term investment and financial success.
Ryan P. Dolan
Managing Partner
Dolan Partners LLC
ryanpdolan@dolanpartners.com
www.dolanpartners.com