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June 16, 2014

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Overcoming the perils of going-it-alone investing

Source: Shanghai Daily | June 16, 2014, Monday | Print Edition

RATHER than delegate to professional investment managers, some investors prefer to invest directly on their own. Of course, this can be a successful strategy, but be sure to consider what the investment process entails and be aware of the potential pitfalls in taking this route.

There are three key factors that impede our ability to invest successfully on our own: timing, diversification and emotion.

Timing. The key principle to remember about successful market timing is simple: You can’t consistently do it, and it is dangerous to try. A simple analysis of the best and worst performing asset classes in any given year will highlight the unpredictability of markets. Furthermore, if attempts to time the market fail to capture the best-performing days, then total performance will be devastated.  For example, if you had invested US$100,000 in a US equity on the S&P 500 Index in 1989 and remained invested until 2013, you would have a current portfolio value of US$1,018,000.  If your investment across the same period missed the top-five days in the market, the value of the portfolio would be only US$675,000.  Many investors fail to achieve their long-term performance goals specifically due to attempts to time the market.

Diversification. This is often cited as the holy grail of investing, but it involves far more than simply “not putting all of your eggs in one basket.”  By combining assets that follow uncorrelated return paths, you are able to lower portfolio fluctuation at a given level of target return and increase returns at a given level of risk.  No one likes to see the value of their portfolio decline, and through careful portfolio construction you end up with less heartburn in your investment plan.

Emotion. Everyone is affected by emotion when it comes to investing.  We each tend to hold on to our losing positions for too long because we are reluctant to admit a mistake and harbor hopes of a comeback.  We also tend to sell our winners far too soon because it can feel self-affirming to “take profit.”  Investors also tend to favor investments with which they are familiar.  This “home bias” affects us all and can result in excess risk and/or suboptimal concentrations in portfolios.

So how do we overcome these pitfalls? It is essential to first determine a strategic asset allocation that represents a carefully selected asset class mix as a starting point for the investment of long-term assets.  The determination of this optimal asset mix requires a reasoned view across global asset classes in terms of their return expectations, their risks and, most importantly, how they are likely to interact over 5-7 years.

To determine asset class mixes that are likely to maximize return and minimize risk is a complex exercise.  Once an array of optimal mixes is determined, selecting a particular strategic allocation then requires a level of reflection regarding your own personal risk tolerance.

There will be short-term periods throughout the economic cycle when certain investments may become over- or undervalued.  Therefore, it is essential to be regularly apprised of market developments in order to make tactical adjustments to your long-term strategic allocation.  For such tactical asset allocation tilts to be effective, they must be implemented in a timely manner to capture fleeting opportunities.

Finally, it is also important to monitor the specific investment instruments selected.  Underlying investments such as stocks, bonds, investment funds and hedge funds all require constant monitoring to ensure they continue to satisfy the criteria that applied when they were selected.

Robust portfolio construction consists of an informed strategic asset allocation, timely tactical allocation tilts and ongoing instrument selection and monitoring.  A disciplined process is pivotal in supporting the achievement of long-term financial goals and can address potential pitfalls in timing, diversification and emotion.

Finance Special


 

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