When the Smart Money Does Dumb Things

Investors can a learn a lot from pension funds, particularly when it comes to diversification, risk management and long-term thinking. But it seems professional money managers are not immune from the behavioural challenges that plague retail investors.

Doug Cronk, who writes a useful blog called Institutional Investing for Individual Investors, recently pointed me to a couple of industry articles that make it clear the pros are just as human as the rest of us. (I interviewed Doug last fall for an article called “Invest like a pension fund manager” in Canadian Business.)

In a February article in Pensions & Investments, a strategist explains that many pension funds have an investment plan that calls for them to increase their allocation to bonds when their plan is well funded. This is what investors might call “taking risk off the table”: the idea is that if equity markets have been strong and you believe you’re comfortably on track to meet your goals, you can afford to reduce the risk in your portfolio. However, the strategist says many fund managers are reluctant to carry out this plan: “According to their glidepath they should be starting to shift asset allocation now,” he says. “But they have this view of the market that equities are going to outperform bonds. They don’t want to do it yet.”

In other words, the fund managers are ignoring their own investment policies and taking on more risk than they need to because they’re caught up in this long bull market for stocks. They’re reluctant to invest more in bonds, even though the role of fixed income is to manage risk, not deliver higher returns than equities. Sound familiar?

Doing the right thing feels wrong

Another item from Aegon Global Pensions suggests this isn’t the first time investment committees have made this error. The right time to reduce risk in a portfolio is after equity markets have performed well, but that is also the time when it no one wants to consider it. And of course, the worst time to move to safer investments is after equities have already plummeted, but that’s when we’re most likely to do so—and that’s true for pension funds as well as Joe and Jane.

“When derisking was affordable, it was not perceived as being desirable,” the article says. “In 2008 however, derisking was seen as being desirable but was also perceived (rightly or wrongly) as being unaffordable.” In 2014, after several years of strong equity returns have put many pension funds in a stronger position, “derisking” has become affordable again. “However, it is very hard to persuade both members and sponsors to derisk at such a time, as equity markets are rising, interest rates are low and hedging seems both expensive and unnecessary.”

This is yet another reminder that successful investing is not about having superior knowledge, or access to the best research. Chances are every pension fund manager have those things in spades. It’s not even about having a thoughtful plan, because the pros have that, too. The real key to success is having the discipline to stick to that plan when your instincts are telling you to change course.

40 Responses to When the Smart Money Does Dumb Things

  1. Trevor March 20, 2014 at 10:11 am #

    Interesting read. As I was reading I couldn’t help but think about Warren Buffet’s quote “Be fearful when others are greedy and greedy when others are fearful.” Although pension fund managers have concrete evidence (i.e. dollar values) that their funds are well funded when markets are strong, they can’t make the contrarian decisions mandated by their policy.

    If this sort of cognitive bias exists and is difficult to overcome in a professional money manager, imagine what exists in your typical Canadian retail investor!

  2. Karim March 20, 2014 at 10:38 am #

    There is an interesting post in the financial post:

    http://business.financialpost.com/2014/03/20/the-secret-trading-strategy-from-the-1930s-that-hedge-funders-dont-want-you-to-know-about-2/

    I guess if you do take the emotions out of investing, you may not be buying when others are greedy!

  3. Jordan March 20, 2014 at 10:45 am #

    Hello,

    Nice article as usual. I’m in this predicament regarding bonds as well. I’ve been investing for a couple years now and have generated a portfolio of entirely stocks over a time period where I felt stocks had considerably more upside. Now I’m starting to feel the need for balance, especially after since stocks have done so well and look somewhat expensive. However, I look at bonds and wonder where the upside could be? Rates are bound to rise at some point, are they not? So, like Doug, I’m still buying stocks, as I feel like they might be the lesser of two evils, though I want to get into bonds eventually. Do you think this is a fool’s errand waiting for bonds to become more attractive? I’m in my mid-twenties, if this is a factor. Thanks!

  4. Trevor March 20, 2014 at 10:55 am #

    Jordan, as CCP says bonds are more about mitigating stock risk and not necessarily getting solid returns.

    I’m in my late twenties and currently have no bonds in my retirement portfolio. My time horizon is long and I don’t plan on touching the money any time soon. I’m also fairly confident I can tolerate volatility in my holdings (meaning, if my indexes drop 30-40% I won’t freak out and panic sell). I probably won’t start adding bonds until my mid 40’s and I will gradually increase my allocation as I age (to mitigate risk).

    Reflecting though, perhaps this is my manifestation of overconfidence (I have never been in the market in a big crash).

  5. Canadian Couch Potato March 20, 2014 at 11:11 am #

    @Jordan: I think it’s fair to say that stocks almost always have more upside: if they didn’t, no one would tolerate their volatility. My suggestion is to choose a target asset mix that is suitable for your situation (and that might be 100% stocks, though few people can endure that) and then stick with it rather than worrying about when each asset class appears to be “attractive.” One of the lessons from this blog post is that when assets eventually become attractive, no one wants to buy them.

  6. harveyM March 20, 2014 at 12:38 pm #

    I think it is increasingly becoming more difficult to be a solo DIY investor because of information overload in this internet/television instant news age! There is so much distraction which fuels one’s instincts to panic or become greedy instead of following one’s plan. I think part of one’s discipline is to read only this sensible blog to the exclusion of everything else. Drastic suggestion but prudent no? One needs to see investing not as a hobby with its hours spent reading numerous investing news sites but instead a formula to religiously follow over the long term. Thanks Dan for your good work 🙂 helping us to remain focused!

  7. Oldie March 20, 2014 at 1:47 pm #

    This is a demonstration of how difficult it is for professionals to carry out what they are supposed to be the most expert in — Active Management. The lesson I take away from this is, yet again, it shows how unlikely it would be for me, average Joe, to achieve my target if I tried, of beating the Index over the long haul, and how disciplined Passive Index Investing is the only rational way to go. No trying to decide all the time if one is being too “fearful” or too “greedy” — just rebalance and don’t even look (if you can bear it) till next year.

  8. Oldie March 20, 2014 at 2:10 pm #

    @CCP: Concerning portfolios comprising 100% Stocks, while it is true that 100% Stocks has more upside than 100% Bonds, isn’t it also true that even if one wanted to be very aggressive, a portfolio having, say, 80% Stocks and 20% Bonds may (depending on the correlation) have more upside than one’s first intuitive guess of about 0.8 of the upside of a 100% stock portfolio, with considerably less volatility?

  9. Jordan March 20, 2014 at 2:11 pm #

    @Trevor I feel very similarly Trevor. Like you, I’ve never had to endure a big crash either, but after a couple 30%+ years, I’m starting to take a step back and reassess, rather than letting overconfidence get the better of me. I also have been under the impression that I will add bonds later on in life, so it’s nice to get the CCP/Trevor nod.

    @CCP, thanks for your response. I wonder though, the lesson that nobody wants to buy an asset when it eventually becomes attractive – for Doug not wanting to buy bonds at the moment, this isn’t exactly a function of him (like everyone else) not wanting bonds, is it? Bond yields have been driven down due to their demand, have they not? That isn’t to say that I think somebody at the helm of a pension fund should be a “contrarian investor”, or trying to time the bond market. I dig the formulaic, get rich slowly CCP style. Just food for thought.

  10. Canadian Couch Potato March 20, 2014 at 2:32 pm #

    @Jordan: I should clarify that Doug was just the messenger who pointed me to the articles I quoted. He’s not the one doing the “dumb things.” 🙂 In this case, it’s not so much that the asset class (bonds) have become attractive. It’s more accurate to say the strategy of “derisking” has become more attractive and affordable, but the fund managers are choosing to ignore this opportunity.

  11. Chris March 20, 2014 at 3:13 pm #

    The core problem is that these pension funds are typically run by active managers, so it’s wholly predictable that they’re also into market timing.

    It’s like the old Upton Sinclair quotation about how difficult it is to make someone understand something when their salary depends on them not understanding it.

  12. Serge March 20, 2014 at 8:04 pm #

    I would have thought that pension funds did not need to change their risk exposure since their horizon is in theory timeless. Shifting asset allocations after a bull or a bear market sounds a bit like market timing unless they’re just rebalancing.

  13. will March 21, 2014 at 9:26 am #

    There’s one thing I never see anybody mention in this whole bond allocation argument. if you’re pretty sure that bonds are doomed to lose money as rates rise and you’re afraid to invest in them, why not just hold cash for a couple years until rates normalize a little?

    There’s no need to go 100% in stocks just because bonds don’t look good. Sure, cash loses to inflation, but if you believe that bonds are doomed to lose even just ~5% a couple years holding cash is still much, much safer than shifting your whole bond allocation into stocks, right?

    If the purpose of bonds is to simply reduce risk, cash should serve a similar purpose just fine, especially in an environment where bonds are considered more risky than normal.

  14. Canadian Couch Potato March 21, 2014 at 9:51 am #

    @will: I think that’s a pretty common strategy, actually, though it’s probably more common to just move to short-term bonds rather than cash. The problem, however, is not so much that people are afraid bonds are doomed to lose money. It’s more that they’re not content to earn 1% or 2% in cash or short-term bonds when they’re tempted by the promise of double-digit returns in stocks.

  15. will March 21, 2014 at 9:56 am #

    Good point. I think there’s two things going on here. One is, as you say the temptation to earn more which is always there. Usually this is tempered by the need to diversify and be safe though.

    But currently the idea that interest rates will rise and demolish bonds is being used to justify the temptation to earn more by going 100% stocks. If bonds aren’t safe why bother, I’ll just go full stocks instead…

    I think there are still plenty of people out there that can have reasonable concerns about long term bonds and respond by, as you say, simply moving to shorter term bonds or cash.

  16. Golluk March 21, 2014 at 11:43 am #

    I was under the impression that bonds serve two purposes. Firstly, if stocks do badly, bonds are likely to at least do better. Bonds are then sold to purchase low cost ETF/index funds when re-balancing your portfolio. In the current case, if ETF/index funds are doing well, bonds are likely cheaper to buy, or at least a better bet than cash for holding onto the gains that have done better than the long term market average.

    Secondly, bonds are less volatile. So as you come closer to, or are actively taking out money for during retirement, you don’t want to be forced to take money out of investments that may be down 10-20% compared to the long term market average.

    It has only been a month since I’ve started to read and educate myself on long term investing, so I may be way off in my understanding. And does leave me the question of how do you time transitioning to bonds? Or does it just naturally occur as you adjust the percentage in bonds, which would get taken from the currently best/least down investments at re-balancing.

  17. Dave March 21, 2014 at 12:05 pm #

    Dan,

    Another great post.

    So much for the argument that investors need advisors and managers to save us from ourselves.

  18. Canadian Couch Potato March 21, 2014 at 1:07 pm #

    @Golluk: It sounds you have the basics correct. Yes, if you intend to increase your allocation to bonds as you get older, you can simply buy more bonds with new contributions or gradually sell equities when you rebalanced. It’s something that can play out gradually, not a one-time transaction.

    @Dave: Not all advisors and fund managers make these mistakes. As Chris says above, many pension fund managers are very active in their approach. The good advisors encourage discipline and rebalancing.

  19. Dave March 21, 2014 at 1:27 pm #

    Agreed, but it is often the pitch to justify a 1% fee (which in many cases is not good value for money). Active approaches seem to be more about justification than actual after fee results. The “gap” studies continue to show fund investors underperform their funds even with advisors in most cases. It shows that humans are not suited to investing and need to be “tied to the mast”. Simple but not easy. I have a lot of 20 yr old Jason Zweig articles that only need the date changed to be relevant today. I’m betting I’ll be able to say the same about many of yours down the road.

  20. John March 21, 2014 at 2:58 pm #

    I, too, have been struggling with the ‘bond strategy’, and whether to hold cash instead.

    It seems a sucker bet to buy more bond funds when you know the prices will drop due to the “inevitable” rise in interest rates. But if one is holding the bond fund for a long duration, and per CCP we should all have some permanent component in bonds, even if the *price* is depressed, it is still earning a *yield*, that should at least keep inflation at bay to a point. So better to hold bonds for a time than cash, since cash is a guaranteed loser due to inflation.

  21. Raffael March 21, 2014 at 4:15 pm #

    @Trevor

    Having diversity in your portfolio is not only about managing risk, but it is also about being able to take advantage of when a good buying opportunity presents itself. If you are invested 100% in stocks and their is a major market correction how will you buy into the discount?

  22. Trevor March 21, 2014 at 8:58 pm #

    @Raffael I make monthly contributions and rebalance every 6 months. My asset allocation is pretty straight foreword – 1/3 Canadian / US / international equities indexes so I just buy however much it takes to get back to that allocation.

  23. Jim March 22, 2014 at 11:10 am #

    Afternoon,

    Two thoughts to consider: one, if you’re young with good free cash flow to invest, and have a high tolerance for volatility (and can keep your emotions in check), being 100% equity is fine as you can consider your future savings as your fixed income component today. In other words, your annual savings act as your bond reserve fund to be able to take advantage of market corrections. You don’t necessarily need the bond portion since you are a “net buyer” of investments for a long time and should enjoy the cheap prices during corrections.

    Two, if you don’t have a high annual savings rate, a lower tolerance for risk, or are closer to being a net seller of investments (i.e. drawing income from your portfolio) then the bond allocation is your insurance – and you don’t try to make money from insurance, just mitigate risk (inflation risk and economic risk). So therefore you should always have a proper (for your circumstances) allocation to bonds. Money market right now though (at roughly 1.50% return) may be a better insurance alternative then actual bonds (or bond indexes, active managers, etc.) for a portfolio of the fixed income allocation because although your yield may be lower (1.50% versus 2.65% YTM on the DEX Universe Index) you have no downside risk and all the same insurance coverage. So a bond allocation to mid-term corporates and money market may be a better fixed income allocation for the next 24-months of so.

    Lastly, it seems many don’t realize that a bond index is simply a big bond latter (i.e. 500 bonds rolling over all the time). It’s very little different to owning an individual bond latter if allocated correctly. And if the bond latter (i.e. index) drops in value, you are almost certainly assured that the equity portion of your portfolio is appreciating – that’s the balance. it’s okay to lose money on “insurance”, it’s actually the preferred outcome (think house insurance, or life insurance – you want to lose money on them).

    Cheers

  24. Brian March 22, 2014 at 3:48 pm #

    Hi Dan,

    I recently listened to a podcast on wheredoesallmymoneygo.com and you were the main speaker along with your crew at PWL. You noted that one of the things you were mistaken about in the past was that people can manage their portfolio’s themselves. (I’m paraphrasing so please correct me if I misinterpreted). Anyways, it struck me as odd, since the indexing approach seems to be really easy to understand and I have had very good success instituting the CCP approach. Wondering if you could clarify please……

    Thanks

  25. Canadian Couch Potato March 22, 2014 at 4:28 pm #

    @Brian: Clearly many people can manage their own investments. I have long argued that when a person is young, the portfolio is relatively small, and it’s all held in registered accounts, DIY indexing is likely to be the best strategy, since good advisors are hard to find and they can’t add much value in that situation anyway. But when investors are managing a large portfolio across multiple accounts, some of which are taxable, it is much harder, and very few people can do it successfully.

    This post sums up my opinion:
    http://canadiancouchpotato.com/2011/09/30/when-should-you-use-an-advisor/

  26. Carl March 23, 2014 at 8:54 am #

    Your age is the percentage that you should keep in non, no I mean LESS volatile assets.( bonds, property)
    And a year’s expenses need to be in readily accessible assets. The rest you can go out on a limb with.
    Just don’t start thinking that you have a crystal ball!

  27. Gerry P March 23, 2014 at 4:40 pm #

    A wise blog article. Yup, its emotionally hard to rebalance again cuz equities are up, when bond prospects look weak and when so many pundits are saying equities will keep rising for a while. I’m leaning towards selling a bit of stock or stock ETF and putting it into a hi-yield savings account as a way to rebalance, though, as it may provide more stability or “insurance” than a bond ETF for a few years—especially since I’m nearing retirement. Is this market timing? Well–maybe. But when you come down to it, rebalancing, which I do believe in, is also an indirect form of market timing, isn’t it? What do you think about a good high-yield savings account (such as at Outlook) as a partial substitute for bond etf’s, Dan or Justin?

  28. Canadian Couch Potato March 23, 2014 at 7:44 pm #

    @Gerry P: Rebalancing is not a form of market timing. You rebalance because your portfolio has drifted away form its target asset mix, or because the amount of risk you want/need to take in your portfolio has changed. Today, if your portfolio is near it’s targets you should not rebalance. If your portfolio has deviated from its course, you should rebalance. It cannot be market timing if the advice is different for two different investors.

    Using a high-interest savings account as part of your fixed income holding is reasonable: the yield is likely to be very similar to that of short-term bonds, and cash would certainly dampen the volatility of the portfolio. The one downside is that cash will not go up in value during a market crash they way high quality bonds typically do.

    I only get concerned when people say they will hold cash “for a few years” and then move to bonds when interest rates are higher. That’s a form of market timing, and it would not have worked out well over the last five years or so. I believe one choose their fixed income holding according to a long-term plan, not forecasts.

  29. Vincent Duncombe March 24, 2014 at 6:38 am #

    Great article. This makes perfect sense. I have heard it said that it is not a good idea to invest based on emotions … especially the emotion of fear. This is a reminder that we must take a objective look at what we are investing in and why and then make a logical decision rather than just jumping off the roller coaster because we are afraid. Thanks.

  30. Andrew March 24, 2014 at 2:44 pm #

    Trevor
    When I was in my 20s I had a different take on risk than you that relates to the asset allocation life cycle. Just after university was hard for me to save as I had other expenses and a low income and I could not stomach the potential to see several years of saving lost in a drawdown well aware I had time on my side. In addition I was saving for a house so I had an upcoming need for liquidity in my savings.

    One thing I thought about during the financial crisis was if I had several years saving disappear on paper when I was young it might have permanently changed my attitude to be more risk averse. Many people who lost a lot in the financial crisis are still sticking with more bonds and cash, at least amongst those I know, and the comfort level seems to me a function of financial knowledge in general. My parents were born not too long after the Depression, and their parents were in their middle years during the Depression and as a result I have not met too many people from around their generation who were entirely comfortable with high allocations to stocks (another factor is that it was generally harder for the average person to access stock markets back then and banking was lots of CDs and GICs). But just as they became uncomfortable with risk the decades after the depression were probably a better time to be rebalanced toward risk.

  31. Golluk March 24, 2014 at 4:01 pm #

    I was talking with a co-worker who felt that bonds really may not be as safe as they generally are assumed. His reasoning is due to situations like Detroit declaring bankruptcy, affecting any loans they had taken (bonds). I still need to really look into bonds, but my understanding is that situation would affect only a percentage of available bonds.

    Also, if bonds did suddenly start losing value, and they were considered to be a higher risk, investors might be advised to sell. Wouldn’t the expected returns also rise for taking on the now increased risk? To me that sounds like a great chance to buy low cost, high return bonds.

  32. Jake March 24, 2014 at 5:32 pm #

    what is the 20 year return on GIC ladder compared to a tradional bond fund?

  33. Craig G March 24, 2014 at 9:48 pm #

    @Golluk: I’m sure Dan will chime in with a much more eloquent answer, but bonds are issued with various credit ratings. You may have seen phrasing like “AAA”, ” A+”, “BBB” etc. They can also be ranked into “investment-grade” or “speculative-grade” or “high-yield”.

    Generally speaking, the higher the credit rating of the issuer (meaning the safer/less likely to default), the lower the yield requires to entice investors. These safe options would generally include federal and provincial governments, as they are extremely unlikely to ever default on their obligations. Canada doesn’t have a lot of municipal bonds compared to the US but they are much more risky as people can move away from cities much more fluidly than provinces or countries, particularly if the tax rate shoots upwards to try and meet obligations like bond payments. Corporations of all sizes can also issue bonds. The “safer” the bet, the lower yield you may get.

    I don’t know the specifics about Detroit, but I would suspect that their municipal bonds were rated very lowly and speculative (probably “C” grade). In order to convince people to buy those bonds, they had to offer a high yield. It has been a very risky place to invest for a long time now. So someone who decided to buy a Detroit municipal bond was looking at higher risk, higher potential reward.

    Most of us that follow Dan’s advice are in quite safe, investment-grade bonds, mostly Canadian federal/provincial governments and some safe/stable corporate bonds – that’s the main composition of the Dex Universe Bond Index. It is these bonds that allow for a lower risk profile in our portfolio and diversity, since the correlation between bonds and stocks is low (meaning when stocks go down, safe bonds tend to go up). I’m not sure what the correlation between speculative bonds and stocks would be – probably higher.

  34. Peter March 27, 2014 at 6:02 am #

    Another odd question.

    If you are looking at making part of your portfolio fixed income, such as bonds you can look at the bond ETFs, GICs, individual bonds and so on.

    But would you see high dividend paying equities in the same light? There are high dividend ETFs yielding over 4% (which is better than most bond funds now) there are some strong preferred shares out there yielding 6% or more that don’t fluctuate much in price, and even some pretty strong equities such as CPG that have been consistently paying out nearly 7% for years while pretty much staying in the same price range.

    Obviously there are some big dividend payers that can’t maintain the level or are at risk for big drops in stock price. But for those that are clearly stable- a preferred share series from a major bank or something like CPG- would you throw all these into the same Equities basket, or could they be considered a moderately safe fixed income part of your portfolio?

    Thanks again

  35. Canadian Couch Potato March 27, 2014 at 9:31 am #

    @Serge: I would agree that as Canadian-listed ETFs come down in cost the incentive to use US-listed ETFs is reduced. In TFSAs and taxable accounts I would say there is rarely a good reason to use US-listed ETFs at all anymore. In RRSPs you can make a stronger argument because of the withholding tax issues.
    http://canadiancouchpotato.com/2014/02/20/the-true-cost-of-foreign-withholding-taxes/

    Remember that there is no difference in currency exposure whether you use Canadian or US-listed ETFs:
    http://canadiancouchpotato.com/2014/01/13/how-a-falling-loonie-affects-us-equity-etfs/
    http://canadiancouchpotato.com/2014/01/16/currency-exposure-in-international-equity-etfs/

    @Peter: Dividend-paying stocks are not a substitute for bonds in a portfolio. They have completely different risk-return profiles: other than the fact that both generate income they have little in common. High-quality bonds are in a portfolio to protect you when equity markets plummet, and no other asset class does that effectively. In 2008-09 dividend stocks (such as CDZ and XDV) lost upwards of 30% or so, while preferred shares (CPD) lost about 17%.
    http://canadiancouchpotato.com/2011/01/24/debunking-dividend-myths-part-3/

  36. Peter March 27, 2014 at 11:18 pm #

    So I guess there is no shortcut or way to get around the requirement Bond holdings. If it seems to be too good to be true….

  37. A big advantage pensions funds have is lower fees. As we all know, fees can have a big impact by eating away at your investment return long-term. These higher returns have help offset the lower investment returns from safer investments like bonds.

  38. JDF March 29, 2014 at 4:37 am #

    But isn’t this whole “de-risking” a form of market timing? Isn’t that we are all trying to get away from and mitigate by using the Potato method??

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