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Why Don’t Investors Tilt More?

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Your friends and most institutions all have equity portfolios that might be described as domestic total market. If we plot out the characteristics of their investments we would most likely find that the weighted average of the holdings falls dead center of the domestic market. The more adventurous investors may have a token representation of foreign large companies.

These are not terrible portfolios, but they are distinctly sub-optimal. They do have one very large advantage. They don’t have to be explained to anybody because everybody pretty much has the same holdings. What investors hear on the news every night pretty much explains how their portfolio is doing. If the Dow or S&P is down sharply, that pretty much tells you that your portfolio is likely to be down also. Variations in investment performance are tolerably small and intuitively obvious.

Almost everybody they know is in the same boat. That boat is in familiar waters, and it drifts along steered by currents of “the market”. Not too much original thought is required to float along with all your neighbors. It’s a comfortable, but, mediocre ride. The risk of standing out, especially on the downside is minimal. If you get hammered, your neighbor is probably suffering too. So, somehow, sub optimal performance doesn’t seem too bad. No one is going to point to you and say: “That was really dumb.” You might say that the herd is in its comfort zone.

But, what about these portfolios is sub-optimal? And what does sub-optimal mean? A sub-optimal portfolio is one that carries more risk than it needs to in order to achieve a particular rate of return, or one that could achieve more rate of return at a particular risk level. In other words, it falls below the “efficient frontier”.

It’s really pretty easy to design a more “efficient” or optimal portfolio. It’s actually elementary stuff taught in almost every graduate finance class. It’s not a state secret, and it’s not rocket science.

First, we can jettison a boatload of risk by simply shifting from a domestic to a global portfolio. We will have an almost identical rate of return expectation at significantly lower risk. (A global portfolio would have a proportional weighting of all the global equities rather than just the United States. To greatly oversimplify, in round numbers this might be a 50/50 domestic/foreign portfolio.)

We can also increase expected return by overweighting small and value companies in the global portfolio. How much we increase return is directly related to how far we “tilt” the portfolio toward small and value. The Fama-French three factor model identifies small and value exposure as having additional risk premiums over the market. It is widely accepted as the appropriate model for estimating expected returns. Fortunately, while these small and value tilts introduce additional risks, they pretty much cancel each other out (in technical terms they have low correlation to one another). So, while we are taking different risks from the vanilla domestic portfolio, we are not taking significantly more total risk in the portfolio. In round numbers, a pronounced tilt toward small and value on a global basis could increase expected return by about 2% per year. Over an investor’s lifetime, an increase of that magnitude could have a staggering effect on his standard of living and/or financial security.

If it’s so easy, why doesn’t everybody do it? Why are so many investors content to rock along with mediocre portfolio designs? There are costs both real and psychological to adopting more efficient portfolios. The biggest is tracking error. The portfolio is not likely to perform in lock step with the traditional benchmarks or the investors built in mental benchmark. It requires a much higher level of understanding by both advisor and investor before it can be adopted, and the risk of an investor bailing out at the first underperformance against the more familiar benchmarks is real. Both parties must agree to do the right thing and stick with it through the market cycle. Both parties must accept the high probability that sometime during the market cycle even the most efficient portfolio may under perform a naive benchmark. The more pronounced the tilt from the market center, the more pronounced the deviation from the market portfolio.

For several years, a global portfolio tilted towards small and value has been the dominant portfolio. We have every reason to believe that it will be the dominant portfolio over the investor’s lifetime. However, we certainly don’t expect over performance during every time period. Human nature being what it is, investors are generally comfortable while racking up excess returns over the global portfolio, even if they don’t exactly understand why. So tracking error hasn’t been a major problem from 2000 to present (June 2006).

The problem comes if the portfolio underperforms and the investor doesn’t understand why. At its worst, the investor might actually lose money while his friends make money. Then the investor may feel that “something is wrong” or that the portfolio strategy is flawed, or the advisor has “lost his mojo”, leading him to abandon an arguably superior strategy instead of exercising the discipline necessary to achieve his objectives.

  • Many retail do-it-yourself investors have never had a finance course and are unaware of basic portfolio design. The school system has failed to provide them with the fundamental survival tool of basic financial economics. It’s possible to graduate from high school without knowing how to balance a checkbook, and then leave graduate school without ever having an economics or finance course. It’s little wonder that they don’t naturally gravitate to a strategy radically different from what their peers are pursuing.
  • It may be outside the comfort zone of many investors. Straying too far from the herd may make them feel isolated and vulnerable. An efficient portfolio may appear so radically different from their contemporaries that simply “feel funny”.
  • Fama and French have speculated in a recently circulated paper that many investors make a conscious choice to accept lower returns in exchange for the perceived comfort and security of larger growth companies that dominate the market portfolio. These choices reflect the investor’s “tastes and preferences”.
  • Some retail brokers are ignorant of basic portfolio design theory. They are unlikely to advocate a strategy they themselves don’t understand.
  • More than a few retail brokers are afraid that an optimum portfolio may be rejected by customers that do not understand it. For them, it’s an uphill struggle to lead the client to an optimum portfolio. It’s easier to “push them the way they are leaning” in order to get the sale. It may be far easier to sell product rather than advise and educate.
  • Institutional managers and advisors have similar concerns. They know that the standard they are most likely to be measured against is either the S&P 500 or Wilshire 5000. They are not likely to get fired for closely tracking either of these two indexes. Even if the alternative global small value strategy is demonstrably superior, the business risk of being fired for temporary under performance is great. The broker must decide whether he wants to do the right thing or the safe thing that keeps business on the books.
  • Retail brokers and retail investors may not have access to product that allows them to effectively build in a small and value tilt on a global basis. So few of them understand the advantages that there is little demand for the product leading to few fund companies offering advanced solutions.

Advisors and educators are going to have to do more to lead Americans to make better investment decisions. As a society we have failed miserably to school our members on this critical function. Given that the social safety net is rapidly wearing out, perhaps we ought to move basic finance education up a little in our priorities.

Investors are not born knowing the advantages of global diversification or the Fama-French Three Factor Model. Because the superior portfolio isn’t intuitively obvious, they are highly unlikely to stumble on it by themselves. To make matters worse they are more likely to be hit by lightning than have it taught to them in school. At first glance it looks and feels a little funny, and perhaps even radically different. It’s far easier for them to do what everybody else is doing.