When the equity market began a great decline in September 2008, many investors were caught over exposed to the equity market, some surprisingly so, and their losses were greater than it should have been (especially those who sold at market lows). Since research shows that most average investors fail to re-balance their portfolio, and with the equity market trending downward, will investors be caught over exposed to the equity market again? Since once is an accident and twice is a pattern, what are some things people can do to avoid the same fate?
The conventional rule in asset allocation is 120 minus age equals an ideal percentage weight in equities. Since I am self-employed and have equity like returns in my life (when the times are good, they are great, when they are bad…), I have adjusted the rule to 100 minus age to mitigate against a double loss of income from business and investing income/gains.
If anecdotal evidence and academic research is to be believed, most average investors either do not adhere to this rule or start with proper asset allocation and fail to adjust over time. As the book Nudge indicated, in the former case, most average investors tend to over-allocate towards equities. In the latter case, since equities do out-perform fixed equities over time, an investor who fails to reallocate an initially ideal asset allocation is likely to have be over-weighed in equities over time.
Why does this happen? Some common reasons may include:
- Too many products. Again, as the book Nudge found, the more products offered in a pension plan, the more likely its participants had drifted into being over exposed into equities. Balanced funds, income funds, income and growth funds have names which imply stability but they continue to hold equities in them. Combine them with pure equity products and an investor may have accidentally over exposed himself to the equities market.
- Too many accounts. Your 2nd cousin becomes an investment advisor so you open an account with her and put some money in to support the family. You have a second account to do all your investing with an advisor BUT you have a self-directed account as well and you just met some hot-shot advisor who you put a little bit of money in to test him out… Pretty soon, it is hard to keep track of your asset allocation because there are too many accounts to keep track of.
- Failure to keep track/failure to adjust asset allocation to life-style. As indicated above, if you fall asleep at the switch, a once ideal asset allocation can drift into too much equities. Or, the 120 minus age rule simply does not apply since you are in a high risk profession already; it has often been recommended that professional traders, entrepreneurs and other high risk/high reward persons maintain a more conservative than usual portfolio.
The fixes to these issues are simple, mainly:
- Simplify and reduce your investment products. Broad based index funds can cover off large investing categories and people with modest sized portfolios should concentrate their investments in a limited number of products rather than a multiple of niche products. To paraphrase, Sun Tzu, if you invest everywhere, everywhere you will be weak.
- Consolidate accounts or be prepared to take the time to determine asset allocation on a consolidated basis.
- Keep track of your money. Sounds easy enough but hard to do in a world with so many distractions. There are various schools of thought on when someone should reallocate. I tend to look at asset allocation yearly. The key is to actually engage in the exercise of looking at your portfolio and then reallocate accordingly.
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