Behavioral Consequences

It appears as though human beings are wired with certain tendencies that make them predisposed to certain illogical, but predictable errors. The field of study, called Behavioral Finance, studies psychological, social, cognitive, and emotional factors related to investor behavior. There are several factors that explain the changing face of portfolio risk.

First, framing bias occurs when the answer given to a specific question is different depending on the way the question is framed. In the case of changing risk tolerance, investors tend to frame their response or over/under state their risk tolerance depending on the direction of the market. Investors “feel” they have identified a trend by observing performance and adjust their risk tolerance to fit the results of the apparent trend after the fact. In the case of a rising market, investors increase their equity exposure and risk profile because they desire greater returns and feel they have insight into the market and therefore perceive less risk. When markets decline, investors reduce or eliminate equity risk in favor of conservative investment strategies. The problem, as stated previously, is that investors do this after missing the reward or experiencing the pain. This is a direct contributor to the results cited in the Dalbar study.

This perceived insight directly relates to two other behavioral biases, those being recency bias and herding. Recency bias occurs when an individual frames their point of reference based on events that have transpired in the recent past. Said differently, if markets have been good lately the expectation is that they will stay good indefinitely. Recency bias encourages investors to “Let it ride” regardless of any valuation or justifiable logic. This often causes investors to ride an investment up to a new price high, or worse, add to that investment at new price highs without any concern for increasing risk.

The last bias, herding, is the tendency of investors to want to do what their neighbors are doing. That is, they would prefer not to be wrong alone. Investors would rather “feel” like they are as smart as their neighbor and participate in the recent market trend rather than finding values in less popular asset classes. All of these contribute to the psychological behavior that causes investors to overstate their willingness to take on risk in good times and understate it in bad. This is a direct contributor to the results cited in the Dalbar study.

The reality is that investors observe performance and want to participate in gains. As a result they are drawn to it without regard to what has created the performance, inexpensive valuation. As outsized gains are earned, valuations degrade until the point that they are no longer attractive and able to sustain the very result that drew investors in.

Calendar Year Returns

The chart below illustrates how often different styles rotate in market leadership over time and why style diversification may help to minimize overall portfolio volatility. In the chart below, asset class are ordered from top to bottom in terms of calendar year performance.

Historical returns
Source: Callan Associates Inc., 2016