Yield of Dreams

Everything You Know About Portfolio Construction Is Wrong

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In a room full of advisors, it’d be pretty gutsy to suggest they throw out modern portfolio theory, volatility, and past performance. But Thomas Howard, co-founder of AthenaInvest, did just that during the Investment Management Consultants Association’s annual conference in Seattle on Tuesday.

During his presentation on behavioral portfolio management, Howard turned a lot of common investing perceptions on their head. Emotional crowds, he said, dominate market pricing and volatility, but behavioral data investors, as he calls them, can earn superior returns by taking positions opposite the crowds. He told advisors that they’ve got to redirect their own emotions about the markets, and mitigate the impact of client emotions.

To do that, you’ve got to understand the emotional investor, he said. Retail investors are notorious for buying high and selling low, as we’ve written in these pages. But they also can’t think about long-term investing; they’re in a short-term mindset. In addition, emotional investors have a two to one loss aversion, meaning they feel twice as bad about losses as gains.

One way to do that is to take volatility out of the discussion of portfolio construction. “Volatility and risk are not synonymous; volatility is emotional,” he said.

Volatility, Howard said, has little impact on long-term returns. If you look at stock market performance since 1926, the U.S. market produced positive annual returns 72 percent of the time, despite volatility and tail events, he said.

But high volatility is often followed by high returns, Howard said. Emotional investors often get scared of volatility and fall into the volatility trap. And then, they miss the rally that follows.

Howard attributes that to the two-to-one loss aversion, which results in a 5 percent emotional premium on equities over T-bills for those who stay in the market.

“How do you get rid of that? Don’t look at your portfolio.”

Howard advised against doing an annual review with clients to avoid a loss aversion that could lead them to lose that 5 percent premium.

“May there always be people who believe in modern portfolio theory, and make emotional investing mistakes.”

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Casting a gimlet-eye on asset management issues.

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