Investor’s tendency to follow the realized returns may distort the optimal allocation of asset classes in the investment portfolio.
The financial crisis which had begun in 2009 crashed the stock markets and many investors suffered significant losses. One could imagine that this kind of a shock would make investors to critically examine their investment strategies.
However, this has not happened. Investors will make the same mistakes still again, claims Fran Kinniry, a principal in Vanguard Investment Strategy Group
On the Vanguard blog for advisors, Kinniry says that Investors continue to follow returns.
Since the depth of the 2008–2009 bear market through October 31, 2013, the global equity allocation for investors increased from 38% to 57% , which exceeds the 20-year median equity allocation of 51%. According to Kinniry, this increase was driven by the fourth-largest equity bull market in history, which so far has provided a cumulative return of 198%.
In other words, investors tend to flee stocks during downturns and become enamored with them again after upswings. That is same as it ever was, Kinniry says.
Why the tendency to follow returns is problematic?
Key issue is rebalancing. “Historically and mathematically, rebalancing opportunities occur when there is a wide dispersion between the returns of different asset classes, such as stocks and bonds”, Kinnery says.
So what is rebalancing? It is the process of realigning the weightings of investor’s portfolio of assets. Rebalancing involves periodically buying or selling assets to maintain investors original desired level of asset allocation.
For example, investors desired asset allocation is 60 percent stocks and 40 percent bonds. If stock prices go up, allocation to them might rise to 70 percent. Then investor has to sell some stocks to get back to desired allocation.
Rebalancing is important because it helps investor to maximize return-risk –ratio. Rebalancing keeps investor’s tolerance for risk at the most comfortable level. Hence, it is not about maximizing returns.
According to Kinnery: “Rebalancing is not about maximizing returns, reversion to the mean, or market forecasts—it is about maintaining the risk and return characteristics of the portfolio an investor selected based on his or her unique time horizon, risk tolerance, and financial goals.”