Does choice affect asset allocation?

Posted by on October 19, 2009 in Investment Information

Congrats to David for winning the draw for the book The Secret Language of Money. David has received an email informing him that he was the winner. Thanks for participating and I hope to have at least one more draw this year.

Asset allocation is the strategy of distributing one’s investments across different investment classes. The underlying theory being that, since different assets may not be correlated, a proper asset allocation provides diversification and manages risk. For most retail investors, proper asset allocation is necessary since we neither have the time nor expertise to invest substantially in one investment class. The general rule of thumb is 120- investor age should be your asset allocation in equities (i.e. a 40 year old should have a portfolio containing 80% equities) which replaces the more conservative 100-age rule (the one I follow).

The enemy of asset allocation is inertia. Since assets gain or lose value of time, an investor needs to reallocate their portfolio periodically (annually is typically recommend). Without such periodic reallocation, an investor’s portfolio tends to drift outside their ideal asset allocation to, more often than not, an overweight in equities (since equities have greater returns than fixed income over time). Many investors woke up circa October 2008 to find that they were much more exposed to the equities market then they thought having not rebalanced in the previous years.

But does overwhelming product choice also upset proper asset allocation?

A 2007 study on retirement savings behavior, which also partially formed the research for the book Nudge: Improving Decisions About Health, Wealth and Happiness (an excellent read), found that choice and branding confusion affects investor asset allocation in different manners.

Using the investment patterns of 170 retirement savings plans as a sample size, the authors found the following:

  1. The greater the percentage of equity mutual funds offered to employees as part of the fund selection process, the greater a portfolio was invested into equities.  For example, a retirement plan that offered its members a selection of funds of which only 37% of all options were equity funds resulted in the employees having a mean asset allocation of 48% equities; a similar plan with equity funds consisting of 81% of the options increased mean asset allocation to 64% equities.
  2. Paradoxically, the greater number of mutual funds an investor picks, the more likely an investor reduces exposure in equity funds towards money market and bond funds. However, the allocation towards money market and bond funds is relatively small (3.28%). The authors’ explanation is when the number of fund choices no longer are within 1-4, the investor can no longer allocate among asset classes using some set percentage (25%, 25%, 50%) and adopts more creative asset allocation strategies.  One assumes the investor mitigates quantity risk by drifting towards safer assets.
  3. Branding confusion for balance mutual funds tends to result in high equity weightings. The authors’ findings supported a Vanguard study that even if an issuer creates a balanced mutual fund, consisting of a mixture of bonds and stocks, investors tend to also pair this investment with equity mutual funds, pushing their equity allocation up. For example, investors who invested in a conservative “lifestyle” fund paired this investment with much more aggressive offerings, resulting in a 77% equity weighting. If, in fact, these investors wanted less exposure to equities, they ended up self-defeating this purpose in their other mutual fund selections.

The implications of this study are manifold:

  1. We are strongly influenced by product; perhaps much greater than strategy. Since the study shows  a correlation between the number of equity funds offered to the equity weightings, it follows that the average investor makes decisions based on product selection rather than assessing whether the products actually fit into an over-arching strategy. Product seems to be leading strategy and not the other way around.
  2. The greater the choice, the greater the chance of improper asset allocation. Rob Carrick recently wrote that an investor should only buy 3 exchange traded funds. It is prudent advice since the more product we have in our portfolio, the more likely we are not following our strategy properly. Adhere to the KISS principle.
  3. Don’t buy by name. Actually research what each product contains. As I commented last week, if an investor bought a dividend ETF along with a broad based equity ETF, the investor has created overlap and may not be any further ahead. Don’t buy by brand. Research how the product fits into your strategy.

Although the research piece dealt with mutual funds, the same analysis should be applied to ETFs. What I hear and read is that many investors are replicating the same mistakes they made as mutual fund investors: chasing returns, buying multiple niche ETFs, creating over-lap in their ETF portfolio, pursuing higher MER ETFS and being interested in what one does not understand (leveraged ETFs). Making a mistake once is a learning experience. Making the same mistake twice is sheer folly.

1 Comment on Does choice affect asset allocation?

By David on October 21, 2009 at 11:58 pm

I have read lots about asset allocation, and often wonder how this applies to me at my stage in life. I just turned 30, and I think I’m pretty open to risk. Currently both my registered & non-registered portfolio are 100% in equities (and our RESP too atm). I’m comfortable with the stocks getting hammered for several years, even welcoming it, as my regular contributions buy more stock, and I’m not planning to touch the money for 20+ years. My plan was not to start allocating bonds for at least another 10 years, (even with the RESP as we’re about 16 years from the first child tapping in to it).

2 things I can think of affect this mindset.

1. Our emergency fund is in a money-market account (essentially a high interest savings account). If this is taken into consideration, then my allocation is much more conservative :)

2. The value of all our investments is relatively small (having only started saving a couple of years ago). A 30% decline is not exactly earth shattering, and I’m confident it will come back up.

Any thoughts?

And thanks for the book, I look forward to reading it.

Write a Comment on Does choice affect asset allocation?


Follow comments by subscribing to the Does choice affect asset allocation? Comments RSS feed.


Read more posts by