The perfect portfolio may not look like what you think. A common fallacy is that good active equity funds should deliver consistently good short-term performance with smooth upward trending returns. Investors who believe this have unrealistic expectations and often dump good investments too quickly thereby losing out on great long-term returns.In his article, Even God Would Get Fired as an Active Investor, Wesley R. Gray, PhD examined the performance of a perfect-foresight fund showing that even with a perfect ‘look-forward’ view, returns would be fabulous, but would also produce significant drawdowns.
Volatile investment performance triggers what is known as loss aversion , with investment losses feeling twice as bad as the comparable gain feels good. This can lead to poor sell decisions prompted by short-term emotional pain, even if the investment objective is long-term growth. Investors suffer from the cognitive error known as representativeness bias , which leads to poor decisions by thinking that recent performance is representative of what it will be in the future. Doing “something” when a fund underperforms in the short-term gives an investor the sense they are in control of their financial situation, but often in reality they are falling prey to the fallacy of control . They blame the manager for the inevitable ups and downs that come with equity investing, and take control by firing them. Done repeatedly, this is a sure recipe for self-inflicted wounds and mounting losses. To help avoid poor decisions driven by loss aversion, be sure to have a long-term portfolio strategy with a disciplined approach to buying, assessing and selling investments. Give managers a minimum of 3 to 5 years and a full market cycle before evaluating them on performance. To discourage focusing on the recent performance of one particular investment, build a portfolio of 5-8 different strategies that are selected to perform well in different ways and in different market conditions. To help hold on during tough periods, take your eyes off the short-term numbers by using a qualitative assessment of the manager. Take the time to understand a manager’s investment strategy. This information will help by addressing important process questions such as: How do they go about making investments? Is the manager staying true to their strategy? How are market conditions impacting the strategy? Join UsFinancial professionals can gain access to additional published behavioral investingresources by registering on our website.