When it comes to investors, you have people like Warren Buffett, and then you have people like my cousin John. Studies show that most investors are more like the latter.
Buffett is, of course, the famous investor who become one of the richest people in the world thanks to his success picking stocks at Berkshire Hathaway, a company that he essentially started.
By contrast, my cousin John got his start investing in the late 1990s, when he read a book on the topic by a professor at Wharton. John is no fool, and he was always skeptical of the "dot com" mania, so he never messed with pets.com, etoys.com, or any of those .com high-fliers that went on to go bust. John stayed invested in some broadly diversified mutual funds through it all.
In the late 1990s, everything seemed like easy money for John, so there was little reason to think too much about what risks he might be taking with his money. Then the "dot com" bust hit, and even though John was not invested in many of those stocks, it seemed like something changed overnight. All the sudden his portfolio was moving three percent or more every day, whereas before a big day had meant a one percent move. John started thinking about all the expenses that he had coming up -- his kids college, a trip he and his wife had been talking about for years, and a retirement home for his parents, and he decided he just could not handle the risk anymore. So John sold near the bottom, and missed out on a steady bull market to 2008.
John did just about everything you are suppose to do as an investor. He was broadly diversified, he did not try to time the market, and he avoided chasing the hot trend of the day. And yet he failed spectacularly, buying near a top and selling near a bottom.
John's biggest failure might have been a failure to actively manage the volatility of his portfolio.
The Traditional Approach to Managing Volatility
Most investment advisors approach risk management by choosing an asset allocation for their client that is supposedly in line with the client's "risk tolerance" (a slightly amorphous concept). There are different approaches to asking clients questions that are thought to measure their ability and inclination to take risk. Once the "answer" comes back, this risk tolerance can be mapped to a suitable combination of risky and risk-free assets that will suit the client's needs.
For instance, after asking a client some questions and running a few simulations, an analyst might determine that it is "appropriate" that a client hold a portfolio with an average volatility of 10% a year. The analyst can then look at the historical volatility of different mixes of assets and pick a mix that is "correct" for that client. Clients with a lower ability or inclination to take risks will end up in investments that are perceived to be "safer," like bonds, while those that are more willing and able to take risks will tend to own a greater portion of risky investments like stocks.
Problem #1: Oops, Volatility Isn't Constant
The problem with traditional Wall-Street risk management techniques is that they do a poor job of producing a portfolio with a constant volatility. In other words, the "risk" of most portfolios is constantly changing, rather than constantly constant. This is because a portfolio with a set asset allocation - say 60% stocks and 40% bonds - will fluctuate much more wildly in some environments than in other environments.
The 2001-2008 period, for instance, was one characterized by what many smart-sounding economists called "The Great Moderation." The "real economy" kept humming along and creating more and more jobs and volatility seemed to disappear from the financial markets - stocks and bonds just went up at a fairly constant rate. Investors slept soundly with their portfolios, and even got a little bit bored and started reaching out on the risk spectrum to buy more exotic stuff that would "move around" more and offered the potential for higher returns.
Then all the sudden 2008 came along and a switch flipped. Where a 1% move in the markets previously would have been considered a big swing, markets started going up or down 3, 5, even 8% a day. Investors who had been sleeping great at night before suddenly woke up at 3 AM in a terror.
Problem #2: Investors Are Not Robots
The problem that this introduces is that based on their risk tolerance, investors are likely to feel a lot more comfortable with their portfolio in some environments than in other environments. Since highly volatile periods tend to coincide with bear markets, there is a strong chance that investors may suddenly "realize" or "feel" that they are taking too much risk during a bear market.
So an investor that was told that a portfolio of 60% stocks and 40% bonds would be within her "risk tolerance" in 2002, might have been fine for the first six years, but then decided in early 2009 that this portfolio was just risky. By the time she threw in the towel and decided that she could not take any more sleepless nights, it was February or March 2009, and she was getting out of equities at precisely the wrong time and totally missing the huge run-up in markets (to above even their previous level in dividend-adjusted terms) that would occur over the next three years.
It turns out that this tragic story of buying high and selling low is disturbingly common - data from financial research firm DALBAR shows that investors habitually underperform the markets because they buy high and sell low.
One Solution: Active Risk Management
One approach to mitigate this risk is to design a portfolio to explicitly target a monthly level of volatility. Volatility can be hard to predict in the long-term, but is actually fairly predictable in the very short term (low volatility periods tend to follow low volatility periods, and vice versa). This makes it possible to explicitly manage position sizes to target a given level of volatility in all environments.
An investor that was actively managing volatility would have systematically and steadily decreased risk to equities as markets become more volatile in 2008. Thus, while there portfolio still would have gone down in value, the size of the swings would not have come as such as shock, and might not have caused such a huge investment mistake.
The travails of my cousin John are an illustrative example. John was invested in a portfolio that was within his volatility threshold in 1997 when the markets were relatively placid, but when "the switch turned" in 2001, suddenly he was unable to stomache the kinds of swings in net worth that he was seeing on a day to day basis. If John had been targetting a specific level of volatility then he would have naturally reduced the size of his positions as the market got more volatile, and he would not have noticed such a difference in the size of the swings.
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