Wednesday, October 25, 2006

working with the investment advisor & the psychology of asset allocation models

I've spent the last few days working with the investment advisor.
It took quite a bit of work collecting financial statements for all of our investments and holdings (not that we have so many assets, but we do seem to have lots of accounts).

The interactive process began once the advisor had received the signed contract, the information and my payment.

So far, we have had several discussions and I have received several e-mails focussing on building the asset allocation model. One of the key points in reviewing each asset class or the ratio of one asset class to another was my tolerance for potential short term losses (what was the worst loss in a 1/3/5/10/20 year period for a specific asset class). Some assets can have significant short term losses that over a short period of time, however, in situations where they have losses over longer periods of time, the size of the loss usually shrinks.

The key matter is ones tollerance for short term losses. Some combinations of asset classes have had one year losses as high as 44%. The critical point is one's ability to stick to the asset allocation model during times of loss. At some point in the year (or more than one point in the year), you would rebalance your assets to return to your original asset allocation model. By rebalancing you end up getting a massive discount on the asset classes that have under performed - in essence you're buying them at their low. You're also selling your over performing asset classes at their high. This is the way investing should be done - buy low, sell high. Unfortunately, most people lose their nerve when one or more asset classes experience significant loss. They sell low and then seek to buy the asset class back when it's high again - what a great way to lose money!

So the key is the ability to stick to your asset allocation model, even when in the short term one or more asset classes perform miserably.

There are other key psychological concepts that I'll mention in a future post.



Anonymous said...

In my opinion, it is more important to look at how your portfolio as a whole performs in the short term. Instead of focusing on individual asset class performance, you need to decide what your overall risk performance is to set your stock vs bond allocation. Then, if you can find asset classes that don't move in the same direction all at the same time (low correlation), you can mix in some of those riskier asset classes without significantly increasing your overall risk of your porfolio. And like you mentioned, when you mix your asset classes, it allows you to buy an asset when it is relatively cheap (buy low) compared to the others.

makingourway said...


You're certainly right about overall portfolio performance - I would even take it the next step and say short term doesn't really matter - best to avoid short term thinking and focus on the long term (but don't forget to rebalance).

However, in this specific circumstance, the discussion is about determining components of the asset allocation model. You're right about stock vs. bond. That was the first thing we did. As we went through each asset class, we discussed the potentials for loss. Most people often forget to look at their entire portfolio's performance and only examine the asset classes that high up or fall far down. It's when they panic at the great falls (rather than wait to rebalance) that they abandon their model and guarantee a loss.

Philosophically, I think we're on the same page - only focussing on different aspects of the process.