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The Power of the Human Mind

The Power of the Human Mind

Investors are often portrayed as rational thinkers who, driven by financial self-interest, consider all the information available to them before making a decision.  But are they?  Do they evaluate their options with clear-eyed objectivity and then make sensible financial choices?  According to the relatively new field of behavioral finance, they do not. In fact, the way your brain works often plays a critical role in your investment decision-making.

A growing number of researchers have found that people’s idiosyncrasies and psychological biases can lead them to act in ways that don’t make financial sense. Investors would do well to keep these discoveries in mind as they make decisions, especially in today’s volatile investment environment.

The Psychology of Investing

Until recently, most financial models were based on the assumption that ordinary people made decisions about their investments the way a mathematician or economist would – logically and rationally.  But in the late 1970s, psychologists Daniel Kahneman and Amos Tversky embarked on research that led to an entirely a new field of study called “behavioral finance.” 

In 1979, they proposed “prospect theory,” which was based on research showing that human beings put “different weights on gains and losses and on different ranges of probability.”1   In other words, people tend to get more distressed by the prospect of a loss than happy about the possibility of an equivalent gain.

A contributing factor to this behavior may be “loss aversion.” Studies have shown that people are willing to take on additional risk simply to avoid losses. They are less inclined to take on the same risk for a potential gain. This tendency may be one reason why investors are twice as likely to sell a winner as they are a loser.2 

Furthermore, investors don’t want to admit when they’ve lost money. “Regret theory” suggests that an individual may resist selling a losing investment simply to avoid feeling sad or anguished about the loss.

But what if an investment is successful?  Enter “overconfidence.” When people have good results, they are liable to interpret it as skill. In reality, it may only be luck. Researchers found this to be true when they analyzed the sports phenomenon of “hot hands.” They studied basketball players who had made their last few shots to determine how likely it was that they would make their next one and found that success didn’t depend at all on the previous shots.3

Human beings also seem to put too much faith in recent experience, believing that they can extrapolate future events from current trends – a tendency called “anchoring.” When a stock price falls, for example, they tend believe the decline will continue and might therefore sell a position prematurely. As more and more people follow suit, this “herding” behavior has been known to result in panics and crashes. Conversely, overly enthusiastic buying may cause bubbles.

Gaining the Upper Hand

So what can investors do to mitigate the impact of their psychological biases on their long-term investment results? The first step is an investment plan. It can help you keep your head when all around you are losing theirs. Other strategies include:

  • An asset allocation strategy based on your goals, time horizon and risk tolerance to keep you focused on what’s most important to you. 
  • Diversification to help minimize swings in the value of your portfolio, which may reduce the temptation to act out of fear or exhilaration. 
  • Dollar cost averaging, in which a designated amount of money is invested on a regular basis and according to a plan, can potentially remove emotion from investment decision-making.   It’s up to you to decide if continuing in such a plan is right for you. 

Human psychology may be powerful, but you can make wise investment decisions despite its influence. For an objective viewpoint, call your financial advisor and ask for assistance.

Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.

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Investing in mutual funds involves risk.  Principal value and investment return will fluctuate with market conditions and it is possible to lose money when investing in mutual funds.


1 “The Ultimate Investor: The People and Ideas that Make Modern Investment” by Dean LeBaron and Romesh Vaitilingam, 1999. (http://www.investorhome.com/psych.htm)
2 “Are Investors Reluctant to Realize Their Losses?” by Terrance Odean, The Journal of Finance, October 1998. (http://faculty.haas.berkeley.edu/odean/papers/disposition/disposit.pdf )
3 “Hot Hands Phenomenon: A Myth?” The New York Times, April 19, 1988.

Is Asset Allocation Enough?

Is Asset Allocation Enough?

Selecting an appropriate asset allocation can be one of the most important decisions you make as an investor. Asset allocation is the process by which you divide your investment portfolio among different asset classes, such as stocks, bonds, and cash. The mix that works best for you may depend on the stage you are in life as well as your time horizon and your ability to tolerate risk.1

But is Asset Allocation Enough? 

Studies and mathematical models have shown that a well-diversified portfolio can reduce risk and potentially increase returns. And while many individuals use an asset allocation strategy to diversify their investments, they often draw the line at U.S. stocks and bonds. 

In Such Cases, a Better Question Might Be: Does Your Asset Allocation Go Far Enough? 

Using a technique called “low-correlation investing,” you can draw on a richer universe of investment alternatives. Harry Markowitz won a Nobel Prize in Economics in 1990 for proving that it was possible to reduce the overall volatility (or risk) of a portfolio by combining investments that were negatively correlated. Investors now use his discoveries to lessen the effect of market swings and potentially improve their returns. This is commonly called “low-correlation” investing. 

Correlation and its Role in Investing

Correlation is a statistical measure that can help you determine how differently one asset behaves from another. For example, if two asset classes are correlated, it means that they tend to move in lockstep. A negative or low correlation indicates that they usually move in opposite directions. (A zero correlation means that there is no relationship between their returns.)
 
According to an article in The CPA Journal, “No one can predict market performance over any time period, short or long, but the study of correlations shows that, over time, different asset types have not performed in sync with the stock market. An investor who holds a portfolio diversified with low-correlating assets has the opportunity to benefit from returns with less risk.”2  
 
To maximize the opportunity, minimize the number of asset classes with strong correlations. If you are invested entirely in equity funds, for instance, you may not want to hold both a growth fund and a blended fund (one comprised of value and growth stocks) because they are closely correlated.
 
Then find asset classes that have consistently lower correlations to the rest of your portfolio. You should also determine if they have the potential to meet your return objectives.  Remember, low-correlation investing is not undertaken for its own sake but as a means of improving your chances of investment success. 

Here are a Few Tactics for Low-Correlation Investing:

  • Mix stocks and bonds – if you’re not already. The high volatility of stocks is tempered by less volatile bonds. That’s because bonds tend to go up when stocks go down (and vice versa).
  • Take a multi-cap approach to stock investing to help you capture opportunities across the spectrum – from large, dividend paying stocks to mid cap and small cap companies.
  • Split your equity investments among value and growth options as well as different size companies.
  • Go beyond U.S. stocks and bonds.  International investments, for example.  Foreign securities do not always move in sync with domestic investments. 
  • Consider non-traditional asset classes, such as real estate. Real estate securities have a low correlation with stocks and therefore can rise in value at a time with stocks decline.

Make the most of mutual funds. They can make the process of mixing and matching securities and asset classes more convenient and relatively less expensive. 

Investing in mutual funds involves risk.  Principal value and investment return will fluctuate with market conditions and it is possible to lose money when investing in mutual funds.  Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility. Holdings in emerging markets entail the further risk of unstable legal systems, increased volatility, and even less liquidity. Investing in sector-specific funds may entail greater risks than investing in funds diversified across sectors.  Because such a fund may invest in a limited number of industries within a sector, the fund may be subject to a greater level of market risk and its performance may be more volatile than a fund that does not concentrate its investments in a specific sector.

To evaluate whether your investments are too closely correlated and to find out what you can do about it, speak to your financial advisor.

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1 “Beginners’ Guide to Asset Allocation, Diversification, and Rebalancing,” U.S. Securities and Exchange Commission. (http://www.sec.gov/investor/pubs/assetallocation.htm
2 “The Power of Low-Correlation Investing,” by Marc D. Stern, The CPA Journal, November 2003. (http://www.nysscpa.org/cpajournal/2003/1103/features/f114203.htm)

Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.

Finding the Right Balance with Asset Class Investing

Finding the Right Balance with Asset Class Investing

Investors are not created equal. Your needs and goals are important factors to consider when you make investment decisions. So is your stage in life. Asset class investing – better known as diversification – can help you find the right balance between risk and reward. It is much easier to keep your portfolio on an even keel if you spread your investments among different asset classes. Studies and mathematical models have shown that maintaining a well-diversified portfolio can reduce risk and increase reward. That’s because all asset classes do not move up and down in value at the same time or at the same rate. When you diversify, you can counterbalance a downturn in one asset class with an upswing in another. The resulting portfolio is likely to provide more consistent performance with less volatility.
 
The greatest benefits of diversification are realized when asset classes are “uncorrelated” or “negatively” correlated. When two investments are uncorrelated, movements in the value of one may have no effect on the value of the other.  And if they are "negatively” correlated, one investment will move up or down in the opposite direction of the other. 
 
For example, bonds tend to be negatively correlated with stocks.  They are apt to rise in price when stocks fall – and vice versa.  For this reason, investors who own both stocks and bonds may find that their portfolio continues to grow as declines in one asset class are offset by increases in the other.  To diversify further, they can invest in real estate or international securities.  Foreign stocks and bonds are relatively uncorrelated with U.S. stocks and bonds. After all, an economic downturn in the United States generally does not impact the securities markets of Europe and the Far East to the degree as those in the U.S.

Diversification Adds Value at Any Stage in Life

A diversification plan can help investors manage their assets throughout their lives. If you are just starting out, your plan might focus mostly on stocks because they offer long-term growth prospects. You could also choose to include bond investments to help you protect money you have earmarked for your first house or for graduate school. Once you start a family, you may want to diversify further and spread your risk. After all, you are probably saving for yourself, your family’s needs, and your children’s education. Then, as you approach retirement, you might decide to re-allocate your investments in order to preserve the assets you have and generate a steady cash flow in the future.

Whatever You Do, Here Are a Few Options Worth Considering:

  • Use mutual funds. By purchasing shares in a mutual fund, you can diversify cost effectively.
  • Look beyond U.S. stocks and bonds.  Other investment styles can potentially reduce the overall risk of your portfolio and help it be a steadier performer.
  • Establish an automatic investment plan. By adding to your portfolio on a regular basis, you can put more of your money to work for you.
  • Extend your diversification plan to all your investments, such as employer-sponsored plans (e.g., 401k, 403b, etc.). 

To create a diversification plan that makes sense for you and your stage in life, speak to your financial advisor. A skilled professional can help you find the right balance between risk and reward.

Investing in mutual funds involves risk.  Principal value and investment return will fluctuate with market conditions and it is possible to lose money when investing in mutual funds.  Investing in foreign markets involves the risk of social and political instability, market illiquidity, and currency volatility. Holdings in emerging markets entail the further risk of unstable legal systems, increased volatility, and even less liquidity. Investing in sector-specific funds may entail greater risks than investing in funds diversified across sectors.  Because such a fund may invest in a limited number of industries within a sector, the fund may be subject to a greater level of market risk and its performance may be more volatile than a fund that does not concentrate its investments in a specific sector.  Using the strategy of diversification does not guarantee favorable results nor does it protect against a loss.

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Eve B. Rose is a business writer specializing in finance and investments. A Certified Investment Management Analyst (CIMA®), she has been writing articles, white papers and shareholder reports for more than 20 years. She is not affiliated with Aston Asset Management LLC and her views do not necessarily reflect those of Aston.

Eight Costly Investment Mistakes (And How You Can Avoid Them)

Eight Costly Investment Mistakes (And How You Can Avoid Them) 

In investing, the only certainty is uncertainty.  No one really knows what will happen from one day to the next.  So smart investors do their utmost to control whatever they can by establishing a disciplined approach to their investment decision-making.  They know, sometimes from painful experience, that even the smallest missteps can undermine their investment returns.

But other investors make the same mistakes over and over again, becoming their own worst enemies.  Fortunately, there are ways to sidestep the most common investment pitfalls.  Here are eight classic investment mistakes and how you can avoid them.

  1. Not investing in the first place.  Sometimes it is procrastination, sometimes anxiety about what to do – but not investing can be the biggest investment mistake of all. 
     
  2. Having no long-term strategy.  When you have somewhere to go, a map can keep you from getting lost.  Likewise, an investment strategy, based on your needs and objectives, can help you get where you want to go.  It can also help you stay focused during periods of market fluctuation – either up or down.  Your strategy should take into account your time horizon, tolerance for risk, amount of investable assets, and planned future contributions.
     
  3. Buying willy-nilly.  Your financial future should not be left to chance.  Construct a diversified portfolio with a personalized asset allocation that includes a range of asset classes and investment styles.  Be careful not to spread yourself too thin.  Over-diversification carries risk, just as concentrated positions do.
     
  4. Buying what’s in vogue.  When everyone seems to be enthusiastic about an investment, the temptation to buy it can become irresistible.  Regrettably, the greater a “hot” investment grows in value, the less room it has to appreciate. You could purchase it just as it starts to cool off.  An old Wall Street adage says that when an investment is hot, the smart money gets out.
     
  5. Exaggerating your abilities.  It can be tempting to “do it yourself,” especially in sharply rising markets. Professionals, however, manage money for a living.  Many spend years in college and on the job, learning their craft.  They also have access to information most individuals do not.
     
  6. Reacting to short-term performance.  Act in haste, repent at leisure.  If you make investment decisions in response to quarter-to-quarter performance or even day-to-day events, you may sell a position prematurely. Instead, you should evaluate your progress based on the asset allocation you put in place.  It is a more accurate measure of whether you are on track to meeting your long-term investment goals.
     
  7. Missing opportunities.  Make the most of your employer-sponsored pension plans by fully funding them and taking advantage of any employer match. Consider putting additional money into an IRA.  Even if your IRA contributions aren’t tax-deductible, they will grow on a tax-deferred basis.
     
  8. Spending your profits.  Put all your money to work by reinvesting your interest and dividends.  Your portfolio benefits when you leverage the power of compounding – the growth of earnings on earnings. 

Our emotions may be part of what makes us human, but we don’t have to let them lead us into error.  Contact your financial advisor if you want help avoiding some of the most costly investment mistakes. 
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Investing in mutual funds involves risk.  Principal value and investment return will fluctuate with market conditions and it is possible to lose money when investing in mutual funds.

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