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Perspectives + Prospects: Behavioral Risk

By Jim Picerno, Director of Analytics


Buckle up to avoid being whipsawed by behavioral risk.


First impressions can be misleading. That’s particularly true when it comes to investments. It doesn’t matter if we’re talking hedge funds, short-term bonds or just about any portfolio strategy you can dream up. In the beginning, the performance will likely be extreme in one direction or the other. That’s not unusual – it’s just math. The lesson: be prepared for a rollercoaster ride until the strategy settles in and delivers something approximating the long-term expected performance (assuming those expectations are warranted).


For example, consider how a simple 60%-40% U.S. stock-bond strategy fared following a January 1990 inception. Early on, there were wild swings in performance. A similar story applies for different start dates.


The good news: As time passes, returns eventually calm down and become contained within a relatively narrow band that’s closer to the asset’s true long-run performance.

The chart is a reminder that the rationale for an asset or strategy isn’t likely to deliver real-world confirmation of the return projections until several years have passed after the initial investment. As a result, the preliminary holding period will probably be noise in terms of the returns (or losses).

Strategy rules are the antidote to market volatility


Emotional decisions are always lurking for investors, as this year’s roller coaster in markets reminds. No one should be surprised by volatility, but how you react is critical. Fortunately, you can manage your emotions, at least in theory.


One way to tip the odds in your favor is to use rules to direct rebalancing events. By contrast, ad hoc decisions – particularly those made during extreme market moves, either up or down – tend to be high-risk trades.


Systematic rebalancing plans can help minimize this threat. Rebalancing triggers used by the Milwaukee Company include calendar-based rebalancing, data-driven rebalancing, and rebalancing when actual allocations drift too far from target allocations, but in each case there is a commitment to a clear, reasonable set of rules.


In addition to being a powerful tool for managing behavioral risk, systematic rebalancing is essential if a strategy is to be tested in advance of being implemented. Moreover, a well-done backtest can provide greater conviction on how a strategy can be expected to perform over the long term, and thereby further reduce the urge to tinker with it.


Rebalancing may not boost returns. Rather, the main benefit is related to keeping the worst of your behavioral demons at bay. As a result, any prudent rebalancing strategy is often better than nothing, but a well-designed and thoroughly tested rebalancing plan is even better – particularly when it’s paired with a diversified portfolio.


What’s lifting stocks?


As Andy discusses above in his Market Musings, by some accounts, the stock market’s ongoing rally is a short-sighted mismatch between Wall Street’s optimism and real-world events weighing on the U.S. economy, which continues to bleed red on several key indicators, including hefty job losses. The bulls counter that the market’s looking forward while the macro data provides a rear-view mirror perspective.


Among the critical drivers for equity prices these days: faith that fiscal and monetary support will juice demand from consumers and businesses as the economy reopens. The next critical event: extending unemployment benefits before the current extension of benefits expire in July.


Perhaps an even bigger factor: the arrival of a vaccine that renders Covid-19 null and void. Count Anthony Fauci among the optimists. The U.S. government’s top infectious-disease expert says there’s a “good chance” a vaccine will roll out before the year’s out.


The market is pricing in the upside scenarios. It’s debatable how much speculation is built into the crowd’s outlook, but risk-minded investors may want to consider the potential for downside surprises. That includes the possibility that a vaccine that takes longer than expected while a second-wave of infections forces another run of economic shutdown. Unlikely? Maybe, but with a market that’s increasingly priced for perfection, Mr. Market’s margin for error is looking thin these days at a time when macro uncertainty is still unusually high.

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