and Behavioral Finance
February 21, 2012
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How’s this for irony? Certain investor behavior creates the conditions for a tactical asset allocation strategy to succeed – but the same behavior simultaneously Increases the likelihood that clients will not follow the strategy.
Recent research by Ken Solow, Michael Kitces and Sauro Locatelli identified a promising approach to tactical portfolio strategy, but our firm’s experience indicates clients will be reluctant to follow this approach –particularly when the expected payoff is highest.
In the January 2012 issue of Financial Planning, Bob Veres reported the results of a survey that he and Advisor Perspectives conducted regarding tactical asset allocation. Of the more than 1,000 advisors in the sample, he found that more than 80% of them expected to make at least one tactical adjustment to client portfolios in the three months following the survey. His survey results correspond with what seems to be a growing interest in tactical strategies by advisors.
Veres’ article came just a month after another that appeared in the December 2011 issue of the Journal of Financial Planning. “Improving Risk-Adjusted Returns Using Market-Valuation-Based Tactical Asset Allocation Strategies,” by Solow, Kitces and Locatelli, advocated making relatively infrequent tactical asset allocation changes at stock market valuation extremes, a strategy that is interesting for two reasons. First, the strategy and its results can be studied over a very long time and through many different market environments, and, second, the market forces that make this tactical strategy promising seem likely to persist.
The authors’ strategy involves a tactical underweight or overweight to equities when the stock market is at unusually high or low valuation levels. Such valuations generally occur when investors are overly optimistic or pessimistic about the future (i.e., euphoric or fearful, respectively). Periods of high valuations, and perhaps excessive optimism, are usually followed by below-average long-term returns. The opposite has also been true – periods of excessive pessimism are usually followed by above-average long-term returns. Their strategy capitalizes on these episodes of extreme investor sentiment and the broad mispricing they create.
Investors have always allowed emotion to sway investment decisions, and it is likely that they always will. The persistence of this market dynamic, however, raises questions about the real-world applicability of any strategy designed to capitalize on it. Any advisor who is considering adopting a market-valuation-based tactical strategy needs to think carefully about its implications.
After all, if extreme stock market valuations occur when the majority of investors are either overly optimistic or pessimistic, how will an advisory firm adopting this strategy convince their clients to run against the crowd? Not all clients will stick with an inherently contrarian strategy, which raises the further question of when clients who abandon the strategy will choose to do so and how that may affect their returns.
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