Many articles have been written about the advisor’s value for investors. Although a generalisation, evidence suggests that clients are better of engaging with an advisor when making investment decisions.
The question that needs to be considered is the source of this “alpha”. In a recent article referencing the work of David Swensen the sources of alpha generation were considered to question what actually drives returns. David Swensen was a legend in the investment community. He was responsible for developing the Yale Endowment Model.
He suggested that a back-to-basics approach is superior to over-complicating investing by trying to do too much. There are three tools at your disposal to generate returns: (1) Asset Allocation, (2) Market Timing and (3) Security Selection. These are the tools that could add value to improve returns. Swensen suggested that, in practice only one of them work. The other two actually result into a net negative.
As evidenced by the research of Rober Ibbotson, 90% of the variability of returns is attributable to asset allocation. Investor returns are explained and defined by their asset allocation over the long-term. David Swensen suggested that asset allocation is actually responsible for more than 100% of the return due to the fact that the other 2 tools available detract from investment return in aggregate.
“The goal of investing is to pick an asset allocation, within your risk tolerance, that should get you close to your future goals. Then leave it alone. Let the allocation do all the work. But that’s not what happens. Instead, investors lean on the other two tools to add value.”
“There’s a behavioural cost too that extracts a bigger cut. Market timing and security selection sound good in theory but play out poorly in practice.”
When investors try to time the market the probability of them getting the direction and timing of it (out -and-back-in) right is excruciatingly small. Peter Lynch suggested that investors have lost more money anticipating corrections than in actual corrections.
We chase performance. Picking stocks or funds have proven to be an exercise of leaning into recent returns. The most famous disclaimer in investing don’t save us from this tendency: “Past performance does not guarantee future results.”
Bottom line – performance chasing dilutes returns.
Research shows that investors (money-weighted) returns underperform the (time-weighted) returns of the funds they were invested in. This is due to buying into a fund after strong recent performance and selling out on subsequent underperformance. Carl Richards refers to this as being the “Behaviour Gap”. This has been confirmed over decades with consistency by DALBAR who have studied the performance and behaviour of investors over decades. We don’t seem to learn.
You get more if you do less.
Asset allocation works best when it’s left alone. Money management works when you are less active. We tend to confuse activity with achievement. Don’t make big changes to your portfolio when markets go through the normal ups-and-downs. Only do this when your own needs or priorities have changed in relation what is most important to you. Market volatility should be expected and baked into the portfolio construction process if done mindfully.
“The first rule of compounding: Never interrupt it unnecessarily.” – Charlie Munger
We would assume that we have a strong interest in avoiding predictable and preventable errors. It is unfortunate that most of the conversations between advisors and clients are still dominated by performance evaluation and the direction of the markets. Beating the market should not be the objective.
Harvesting the returns that the market offers over time is.
Daniel Crosby in his book “The Behavioral Investor” suggests that the most important risk that needs to be managed for investors is their “behaviour risk”, not market risk. Investor behaviour over time explains their realised returns far more than any other factor. We make predictable errors when we experience stress. It is part of being human. We are not wired or naturally inclined to be good investors in a complex world. The body of evidence from behavioural psychology is clear.
The greatest value an advisor can extend to an investor is to mitigate their behavioural risk to remain disciplined through market cycles. Helping clients to make better decisions as it pertains to their own personal values is higher up on the advice value stack than traditional money management.
Better decisions are usually preceded by asking better questions. Better conversations help with creating better awareness. This is where an advisor is indispensable.
Managing “investor behaviour risk” is where true advisor alpha is generated. This translates into both their returns and peace of mind.
The above article was written by Marius Kilian.