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July 18, 2011 at 05:49 AM
Today’s sophisticated investors are plugged into the idea that managing volatility is critical to the well-being of their portfolios. And while investor knowledge of portfolio construction is by and large a positive occurrence, advisors who place too much emphasis on volatility management can inadvertently spook investors into taking overly conservative positions that remove too much risk and diminish long-term return potential.
Rather than burden investors with volatility worries on a tick-by-tick basis, advisors can stimulate more rational, less fear-driven choices by touching upon volatility just annually or semi-annually. Simply put: when it comes to volatility management, focusing on short-term volatility may not be the best solution for clients whose overall objective is long-term growth.
The reason for this over-emphasis on controlling volatility is explained by behavioral finance. In the well-known research paper “Myopic Loss Aversion and the Equity Premium Puzzle” authors Shlomo Benartzi and Richard H. Thaler examine investor appetite for stocks and bonds given the historical discrepancy of their returns. While stocks have pulled in annual real returns of about 7% since 1926, according to Ibbotson research, Treasury bills have earned less than 1%. Such a large chasm in performance raises the question: why would anyone prefer holding on to short-term bonds?
According to the paper, one possible explanation centers on the concept of loss aversion–a phenomenon where individuals are more sensitive to reductions in their levels of fiscal well-being than they are to increases. In other words: an investor feels the sting of $100 loss more than he experiences the joy of a $200 gain.
Short, recurring evaluation periods likewise explain why investors may unduly cling to less-risky investments. Monitoring performance at too-frequent intervals often leads to irrational and unnecessary volatility worries. The net result of these behavioral patterns is too much time spent thinking about and feeling the effects of the downside and not enough thinking about potential gains, despite the fact that gains are what will ultimately lead investors to meet their financial goals.
