By Michael Edesess, Ph.D, Managing Partner / Special Advisor at M1K LLC.
Sticking to your asset allocation, no matter what, might not be the best strategy.
One of the most fundamental precepts of money management is to recommend an asset allocation based on an investor’s risk tolerance and then stick to it, rebalancing regularly to ensure that the allocation stays close to the original recommendation.
Investors are told that this discipline can keep them from getting out of the market in a panic at exactly the wrong time, then getting back in at exactly the wrong time — or, put another way, being fearful when they should be greedy and greedy when they should be fearful.
The mix of stocks and bonds that is usually recommended depends on a client’s perceived risk tolerance, as estimated by means of a questionnaire. A typical recommendation for an investor with moderate risk tolerance is a 60/40 stock/bond mix, though it might be 80/20 for a more aggressive investor, or 20/80 for a highly risk-averse one.
Suppose an investor given a 60/40 recommendation repeatedly gives into fear and greed at the wrong times, failing to follow the strategy properly. How much worse would she do than if she had followed the recommendation to the letter?
The surprising answer: Not much at all. And this raises serious questions not only about the value of traditional recommendations, but about how financial advisers can actually best serve their clients when profitable ideas fly in the face of widely distributed conventional wisdom.
One fear-greed pattern that would have accomplished this historically is to get out of the market whenever it has dropped 10% from its last high point and get back in after it rises 35% from its last low point.
Monthly returns data for the stock market are available from the University of Chicago’s Center for Research in Security Prices for the 91 years 1926 through 2016 — a total of 1,092 months. Monthly Treasury-bill rates are widely available for that same period.
Using these data, if the investor had invested 60/40 in the stock market and Treasury bills for that time period, rebalancing monthly, she would have realized an average 7.64% annual return over the period (and would have been pretty old at the end).
But if she’d entered the market each time it had risen 35% or more from its last low, and then fled after it had declined 10% from its last high, she would have been in the market for exactly 60.1% of the 1,092 months. And she would have realized an average annual return of 7.87%.
There would appear to be little benefit to holding the mix constant. (For this column, I’m assuming the transaction costs could be considered a wash — since the buy-and-hold strategy requires monthly rebalancing and the fear-and-greed approach has its own trading expenses — but the latter might actually be cheaper in many cases.)
There is, however, a potential psychological benefit to giving in to fear and greed. When the investor gets nervous about the stock market dropping, she’ll feel better having gotten out of it. Furthermore, the market has a tendency to become more turbulent when it drops, so she is likely to avoid a discomforting period of turbulence and volatility as well.
When the market goes up, and her greed and sense of missing out increase and intensify, she’ll feel better when she finally gets in, since she can always get back out if it turns down. This is far easier, psychologically, then the discipline required to stick with a strategy of being invested 60% in the market after a precipitous, nearly-50% market drop like the one in late 2008 and early 2009, or in 1973 and 1974.
Let’s suppose the investor flees the stock market in panic after it drops, and gets back in greedily after it has risen, in such a way that she is fully invested in the market 60% of the time and out of it completely, holding only cash, the remaining 40%.
It’s difficult to imagine that advisers will begin suddenly recommending the fear-and-greed approach — or that investors, who’ve been told for decades the value of a stoic no-pain, no-gain strategy, will suddenly adopt it themselves.
But as my calculations show, it should merit serious consideration. Where your money is concerned, every bit of accepted wisdom — right down to the virtues of buy-and-hold — should be examined closely.
Editor's comment: The coolest thing is that Michael didn't have to data mine to know that it wouldn't make a difference. His note said, "No data mining involved, it worked at one try and I knew it would because I understand the math implications of Brownian motion and random walk."
All posts are the opinion of the contributing author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CAIA Association or the author’s employer.
About the Author:
Michael Edesess, Ph.D is an accomplished mathematician and economist with a Ph.D. in pure mathematics in stochastic processes and expertise in the finance, energy, and sustainable development fields. He is an adjunct associate professor in the Division of Environment and Sustainability at The Hong Kong University of Science and Technology, managing partner / special advisor at M1K LLC, and a research associate of the EDHEC-Risk Institute. He is author or coauthor of two books and numerous articles published in Advisor Perspectives, MarketWatch, The Wall Street Journal, Financial Times, South China Morning Post, Bloomberg, Nikkei Asian Review, Technology Review, and other publications, and was previously a co-founder and chief economist of a financial company that was sold to BNY-Mellon. He has chaired the boards of three major nonprofit organizations in the fields of energy, environment, and international development.
Original Article: The surprising reason it might be OK to give in to greed and fear - MarketWatch