Forget the numbers: Back to basics

January 28, 2014 Categories: Portfolio Corner
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Investment numbers

Investing is a numbers game. It always has been and, at least to some degree, probably always will be. Everything is measured. How much return did I achieve? By how much did my portfolio beat the market? How did I do relative to everyone else out there? Some even assess past investment performance using stars: a pictorial method of measurement. The risk is, all of these measurements may open the door for poor decisions.

Let me explain.

With the Russell 1000® Index returning 33.1% last year, while diversifying asset classes (for example, fixed income1 and commodities2) languished, some investors are starting to wonder why their portfolios hold anything but U.S. equities. What can advisors do? Help your clients take a step back from the numbers and return to the basics of investing. How we present choices to our clients may have a great impact on their decisions – and hence on their portfolios.

Take diversification as an example. Although it doesn’t assure a profit or protect against a loss in declining markets, it may reduce the risk of a portfolio without necessarily having to sacrifice return over the long run.  Imagine if, once your client understood the basic definition of diversification, you asked them about the meaning of the phrase “don’t put all your eggs in one basket,” and then you showed them the two portfolio options depicted below. Which portfolio do you expect your client might be inclined to choose?

Comparison of portfolios

*These returns are hypothetical in nature, and are only being used for illustrative purposes.

In contrast, what if you presented the same two portfolio options to the client – but this time the illustration included the portfolios’ past returns? Which portfolio do you think they might choose now?

Comparison of portfolio returns

*These returns are hypothetical in nature, and are only being used for illustrative purposes.

If you chose Portfolio I you’re probably right. That’s because the mind tends to fixate on the portfolio with the highest return – Portfolio I in this case. Upon seeing the return options, the investor is likely to picture what they could have accomplished with either of the portfolios; and more could have been achieved with the higher-returning option. In psychology this behavioral tendency is known as anchoring – relying too heavily on one piece of information when making a decision. Another behavioral trait that may guide the client to invest in Portfolio I is the  fear of regret. Investors start to think that they don’t want to miss out if U.S. equities have another outsized gain.

The point is not to argue that clients shouldn’t care about returns; of course they’re important. Focusing too much on past returns, though, may create less than optimal decisions on the investor’s part, and so should be just one of many ingredients taken into account.

The bottom line

No one can predict exactly when the outperformance of a certain asset class will reverse. But we can say with a high degree of certainty that it will, at some point. Help clients make good portfolio choices by educating them about the markets and the potential impact of diversification. In doing so, be mindful of how you’re presenting choices to your client: are your exhibits potentially triggering behavioral biases like anchoring and fear of regret?

Ryan Hypke is a Portfolio Strategy Analyst for US Private Client Services – PCS Consulting Services Group.

1 Represented by Barclays U.S. Aggregate Bond Index, which returned -2.0% in 2013.

2 Represented by Dow Jones UBS Commodity Index, which returned -9.5% in 2013

Index performance is not indicative of the performance of any specific investment. Indexes are not managed and may not be invested in directly.

Strategic asset allocation and diversification do not assure profit or protect against loss in declining markets.

Russell 1000® Index: Measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1000 of the largest securities based on a combination of their market cap and current index membership.

Dow Jones UBS Commodity Index: Composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as “rolling” a futures position.

Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (Specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

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