The Myth Of The Disciplined Investor

By Benjamin Jang, CAIA, CIM, DMS


Read “The Myth Of The Disciplined Investor” in PDF format.

Jonathan Swift, an influential writer during the Age of Enlightenment, was a very astute observer of human nature and behavior. Many of his observations centuries ago can be seen in the behavioral and cognitive biases that drive investor sentiment today, clouding judgment and leading to ill-advised decisions even when there are well laid out plans.

When investors make emotional decisions under stress, publicly traded markets become volatile, which then creates more stress – irrationality begets volatility, and on and on. People rarely exhibit the logical “Spock-like” behavior ideally suited to investing and make mistakes that become very expensive over time.

The Quantitative Analysis of Investor Behavior (QAIB) study by research firm DALBAR has recently included the effects of emotions on asset allocation returns in its 2013 report and found that the average individual U.S. investor underperformed both the markets and a portfolio of professionally managed funds.

According to DALBAR, over the last ten and twenty-year periods, the investors in the study earned a net return that was less than inflation. That means effectively a zero “real rate of return.” In our view, most investors need a real rate of return of at least 3% per year net of fees and inflation to achieve their long-term financial goals.

Asset Allocation

How Does The Average Investor Fare?

Taking a look at different market environments, the average investor has fared poorly in most market environments. They have historically realized returns close to or below that of a fourth quartile U.S. balanced fund manager in both up markets and down markets, losing 30.53% in 2008.



When looking at the impact of behavior on investor return, the results are compelling.

Many investors buy an asset after a run-up in prices because they feel “more comfortable,” but often this results in the investor buying into the market after a large rally, or selling out of the market when valuations are low – exactly the opposite of what should be done.

Stop Mixing Money And Emotions

Behavioral finance is a field that combines cognitive psychology with economics to help explain the irrational choices that cause investors to make poor investment decisions.

Developed by Daniel Kahneman and Amos Tversky in the late 1960’s, behavioral finance has continued to gain traction as they were awarded the Nobel Prize in Economics for their research in 2002. There are many behavioral and cognitive biases that have a direct effect on investing.

Proper investment planning requires the ability to recognize irrational investor behavior and take them directly into account. This starts with asking the appropriate questions to reveal the characteristics of a particular person’s biases. Not only are the specific questions important, but how the question itself is framed is equally important to truly revealing and understanding a person’s behavior.

Which investor type are you?

The following are some of the more pervasive biases:

Anchoring occurs when a decision is based or anchored solely on a specific reason or value. Closely related to anchoring is the Gambler’s Fallacy where people focus on the reversion to the mean when in fact the mean itself could have changed. [E.g. Late investors in Blackberry believed in a turnaround story, but as its price dropped they were anchored into their purchase price and found it difficult to sell at a loss even though Samsung and Apple continued to take market share and develop more advanced phones.]

Confirmation Bias occurs when an investor has preconceived notions and they actively seek out information that supports their beliefs. This bias is dangerous because seeking out evidence for false positives is a critical aspect of investment research and decision making. [E.g. An investor reading about the next greatest technology such as 3D printing and then actively seeking out other articles which strengthen their view of this new revolutionary industry without considering other factors and the anticipated hurdles.]

Status Quo Bias is the tendency to not make any changes even though rational logic would suggest taking action would be prudent. As noted by a number of studies, people have more regret of a negative outcome when they took action versus having done nothing. The status quo bias is similar to Conservatism where beliefs are insufficiently revised even when presented with new information.

Recency Bias is the opposite of the status quo bias and conservatism where a disproportionate weight is attributed to recent observations. Market observers have humorously noted that market cycles are between 5 to 7 years because of investor long term memory loss.

Loss Aversion is the tendency for people to put more weight on losses rather than gains – the discomfort of losing something is greater than the pleasure of acquiring it. This is somewhat parallel to the Endowment Effect where people will often desire a higher selling price for something they already own, compared to the price they would pay for the exact same item. [E.g. When homeowners sell, they generally list their homes at very high prices believing that it is fair value, but acknowledge that they would not purchase their own home for the same asking price.]

Overconfidence Effect is, as the name suggests, the tendency to be overconfident. Often surveys will ask if a person thinks they did better thatn average to which most people will say yes; however, it is not mathematically possible for the majority to be better than the average.

Herding Behavior is a phenomenon that creates irrational market bubbles and stems from people’s desire to ‘not miss out’ or ‘seek the safety of others’. A wise Chinese proverb says “follow the herd to the slaughterhouse”. Sometimes trends last much longer than initially thought possible so one should not be a contrarian for the sake of being a contrarian, but having the skills to “lean against the wind” and be open-minded is a key success factor. [E.g. When people piled into internet companies during the dot-com bubble and felt safety because others were doing so; over exuberance and speculation drove the Nasdaq up quickly. Investors eventually suffered large losses as they did not focus on the fundamentals and valuations that drive long term stock performance.]

Mental Accounting is the cognitive process where people split items, such as investment assets, based on specific end-uses, rather than viewing all of the investment assets as being integrated and this creates inefficient asset allocation and diversification decisions. [E.g. Investors often focus on the performance of one specific investment (or asset class) without considering how it fits into the overall portfolio strategy. For example, one might focus on the near-term decline in the price of gold relative to stocks and decide to sell their gold holdings; meanwhile gold was initially held to “hedge” the risk of the overall portfolio as it tends to rise in price during times of crisis when stocks and other assets are declining, thus reducing the volatility of the overall portfolio.]

Using Investment Strategy To Ease Your Fear

Portfolios need to be truly diversified – this is not as easy as it sounds.

Too often, investors assume that a portfolio is diversified because it has a number of different assets, but upon closer examination, many of these assets move in tandem and are more correlated than what is ideal to achieve a reasonable level of protection.

The issue of correlation becomes even more complicated, because of the many ways it can affect portfolio volatility and, thus, influence investor behavior.

Put another way, traditional bond and equity portfolios use assets that tend to be more correlated, meaning the whole portfolio tends to be more volatile during market cycles.

As humans, we are emotional creatures, and that volatility – those ups and downs – pushes all the right “behavioral and cognitive biases” (read: greed and fear), causing us to make ill-advised investment decisions.

Not only have correlations between global equities and other assets classes increased steadily over the long-term, but correlations between securities within an index itself have also experienced significant increases, especially during downturns.

In the examples below, correlations range from 1.0 to -1.0, with a value of 1.0 meaning that assets move together in the same direction, -1.0 meaning that assets move in the opposite directions, and a zero value signifying no co-movement.

  • Based on studies from State Street Associates Center for Applied Research, the correlation of weekly returns for 19 different MSCI national indices from 1996 to 2011 has increased from a low of approximately 0.45 in late 1996 to a high of 0.85 in 2008.
  • According to Bianco Research, the average correlation between stocks in the S&P 500 was at a low of approximately 0.18 in early 2000 and reached 0.80 at the end of 2008 – the last time these levels reached 0.80 was back in October of 1987 and the historical average has been around the 0.30 level.

We believe portfolios need to improve diversification by adding non-traditional assets such as private equity, infrastructure, physical real estate and other alternative strategies in order to get the best possible expected return for the level of risk, reaching the efficient frontier of a portfolio.

Diversification: Reduced Risk, Better Return

An efficient portfolio will provide greater return for similar risk or similar return for less risk; this is accomplished primarily by combining assets that are not highly correlated with one another. For a number of years, many institutional investors have been combining traditional and non-traditional assets. As shown in the chart below, Yale University’s endowment fund is an example of an institutional approach to diversification:


Essentially, the allocation to public stocks has decreased and investment in non-correlated private equity and real assets has increased – the focus on absolute returns plays a bigger part.

For the individual investor, however, the ability to access alternative investments has been limited. This is frustrating, particularly for high net worth investors who have the ability and willingness to invest in alternative assets, but are unable to find a solution that properly addresses the unique risks associated with investing in alternative assets.

With the number of alternative assets that are available, taking an institutional approach to private wealth management does not seem difficult; however, there are a number of issues to consider:

  • It is often difficult for investors to access these investments, either because of high minimum investment levels, difficulty in performing due diligence of non-traditional investments, or the high level of fees involved if a lower fee rate cannot be negotiated.
  • Many investment managers are heavily constrained to traditional asset classes. This can occur if the manager has a specific mandate and/or the firm has not yet embraced the proven benefits of non-traditional investments. Portfolios with open mandates have the ability to focus on real or absolute returns (i.e., above the rate of inflation), versus just being compared to a benchmark.
  • Many managers are not only constrained to the type of investments, but also to the strategies they are able to employ. For example, many bond fund managers are limited to how much the duration of their bond portfolio can deviate from a benchmark. During certain economic environments, however, these types of constraints can increase risk considerably, even if the investment mandate is not aggressive. Furthermore, the ability to access non-traditional securities such as options can help reduce volatility or enhance profits during sideways markets.

In contrast to the traditional 60/40 equities/fixed income portfolio, NWM takes an institutional approach to private wealth management. Consider the various types of asset classes that are the basis for NWM’s client portfolios:

NWM Portfolios

In this global market environment where investments are bought and sold not only based on each asset’s intrinsic qualities, but also based on “risk-on” or “risk-off” market sentiment, a more robust approach to diversification is needed.

To achieve this, an investor needs to take a multi-dimensional approach to diversification where:

  • Asset classes are not highly correlated with each other.
  • A significant part of the total return (more than 50%) is derived from stable cash flow (rents, interest and dividends).
  • Portfolios include non-traditional asset classes such as private equity, real estate, infrastructure, insurance, and annuities.

The impact of globalization can be felt in the increase in financial contagion risks. The increased interdependence of global capital markets means that prudent risk management is more important than ever. For individual investors this means:

  • Understanding traditional market and asset risks.
  • Recognizing the increase in correlations amongst asset classes (less diversification).
  • Acknowledging less tangible risks such as investor behavioral and cognitive biases.
  • Addressing practical risks such as outliving one’s retirement assets or not leaving the size of estate required to fulfill one’s desires for a legacy (either for future generations, philanthropy or both).

In order to properly address all of the real risks related to retirement, a comprehensive and integrated approach combining financial planning, insurance and portfolio management is required.

This is a key ingredient for controlling the emotional biases that humans are all susceptible to, allowing our clients to focus on doing what they enjoy the most and not having to worry about the day-to-day fluctuations in the markets.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. NWM fund returns are quoted net of fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.