Insights

Five ways your investment process can go wrong

  • Written By: Nick Murphy
  • Published: Wed, 08 May 2019 13:29 GMT

Even the best-laid portfolio plans can be derailed by financial market caprices, but charity investors can give themselves a better chance of achieving stable, long-term returns by avoiding a number of common mistakes. In our experience, here are the main five ways that an investment process often goes wrong.

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1. Focusing on the short-term, at the expense of the long-term

When managing portfolios, investors need to consider both strategic and tactical asset allocation. Strategic asset allocation is the long-term allocation to bonds, equities and other assets based on an investor’s risk parameters and goals. Tactical asset allocation is shorter-term, aiming to adjust for temporary anomalies in markets, either to capitalise from mispricing, or protect portfolio returns against volatility.

To our mind, strategic asset allocation is similar to climate. Climate shapes the long-term trend that sets the overall risk reward situation and changes slowly. For example, is the climate getting hotter (inflationary) or colder (deflationary), which in turn sets the tone for what works best overall in markets. Tactical asset allocation is similar to the weather forecast. Do we need to take an umbrella when we leave the house tomorrow? Weather changes all the time, it accounts for most of the ‘noise’ in markets and it is what drives 90% of the discussion you hear from market commentators.

It is easy to spend a lot of time talking about the weather (and many fund managers enjoy doing it) – politics in Europe, the latest manufacturing survey, the US/China trade negotiations, the latest employment numbers etc. However, this can be a distraction from the more important business of establishing the investment climate and detecting changes.

2. Assuming the future will be like the past

Often, investors will use the past behaviour of different asset classes to set their asset allocation today. For example, they may assume that because bonds have performed well at times of declining equity markets, they will continue to do so in the current volatility. However, interest rate levels are very much lower today, economies and policies change and the past may be very different to the future. This has been particularly true in the wake of the Global Financial Crisis as quantitative easing has distorted all markets.

For example, historic annualised returns on a basket of investment grade bonds have been over 5% but bond yields used to be far higher. It is likely bond returns will be structurally lower going forward and those who expect returns to continue at of 5% per year could be disappointed.

If you set your asset allocation and portfolio construction based on historic return and risk expectations, you might well find that your portfolios are not as diversified as expected.

In building the right asset allocation, we need to incorporate in a sensible estimate of forward returns from various markets and the level of correlation between assets in different environments. While we cannot do this with accuracy, it is far better than assuming tomorrow will be exactly like yesterday.

3. Believing asset allocation is all that matters

Does the following sound familiar? “One study suggests that more than 91.5% of a portfolio’s return is attributable to its mix of asset classes. In this study, individual stock selection and market timing accounted for less than 7% of a diversified portfolio’s return.”

This is one of the most misquoted statements in the financial world. The original 1980s study by Brinson, Hood and Beehower found that asset allocation accounts for c90%+ of the variation in a portfolio’s quarterly returns, not the level of returns themselves. This is an important distinction.

That is not to say that getting the asset allocation mix right isn’t important. A 2000 study by Ibbotson and Kaplan found, “40% of the return variation between funds is due to asset allocation”, but it also found that the balance was due to other factors, including asset class timing, style within asset classes, security selection, and fees.

In other words, investors cannot neglect the other elements in a portfolio believing that asset allocation is the only determinant of returns. Investors who do this often tend to populate their portfolios with passive funds, rather than actively selecting their holdings. Passive funds essentially follow a momentum strategy where the strategy is to buy new stocks when they are expensive and sell them when they are cheap. One study found that from October 1989 to December 2017, the performance of stocks added to passive portfolios lagged those that were sold by an average of over 22% over the following year. This is the opposite of what famous investors such as Warren Buffet have advocated their whole careers - buying quality stocks at cheap prices.

To our mind, stock selection is also a key part of overall investment returns and risk control, one where expertise can add significant value. Some market participants and other investment houses have given up on this part of the process.

4. Falling prey to behavioural biases

As humans we make poor investors because thousands of years of evolution mean that we are hard wired to certain behaviours. This is often seen as a problem only for hobbyist investors, who get caught up with fads, such as the technology bubble. There may be some truth in that, but all investors – including professional investors – are vulnerable to these issues no matter how many years of experience they have.

Over 100 behavioural biases have been uncovered, but there are a number that are commonplace: anchoring, for example, is when investors make decisions based on an arbitrary reference point. Gambler's fallacy is an assumption of reversion to the mean in circumstances and in series when there is no evidence that it exists. At the same time, investors may be over-confident. This is particularly applicable to financial market professionals who may be very knowledgeable about a subject area and inclined to neglect information that is contrary to their view.

The phenomenon of ‘herding’ may be familiar. Investors’ inclination to run with the herd, rather than strike out alone, is the key reason that investment ‘bubbles’ form. It feels comfortable to act in the same way as other people, but the herd is not necessarily right, as many investors found out painfully when the technology bubble crashed in 2000.

Investors generally dislike losses (loss aversion) far more than they appreciate the equivalent gains. This can make them act irrationally, by taking much bigger risk to avoid a small loss, even when it would be far outweighed by the potential gain. Recency bias is a tendency to place greater weight on recent events, even when there is no reason for them to be of more importance.

What can we do about these behavioural biases? Being aware of this kind of problem is the first step in trying to avoid them. Quantitative models help us to look at markets objectively and ensure we are looking at the same data in the same way every day, month, quarter, year when we review portfolios and make tactical asset allocation decisions.

5. Ignoring portfolio construction and diversification

It is easy to spend a lot of time focusing on selecting individual assets, without ever looking at how they come together in a portfolio. Portfolio construction is vitally important: markets rarely remain in equilibrium for long and always retain the potential to surprise us. Rising interest rates, geopolitical risk, environmental change and ‘black swan’ events can all derail a portfolio in spite of the most meticulous planning.

While it is clear portfolios should be biased to what you think is most likely to happen, it is also important to consider that we might be wrong. Portfolios include assets that would also do well if the unexpected happens or the initial analysis was incorrect. A common mistake is to think that financial markets will give you time to reposition: they often don’t. The common example given is the narrow door of a cinema with a fire.

Notes to editors
Smith & Williamson is an independently owned professional and financial services group with over 1,700 people. The group is a leading provider of investment management, financial advisory and accountancy services to private clients, professional practices and mid-to-large corporates. The group has twelve offices; these are in London, Belfast, Birmingham, Bristol, Cheltenham, Dublin (City and Sandyford), Glasgow, Guildford, Jersey, Salisbury and Southampton.

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.

Smith & Williamson Investment Management LLP
Authorised and regulated by the Financial Conduct Authority
Smith & Williamson Investment Management LLP is part of the Smith & Williamson group.

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