Second biggest investor ­mistake

George W. Karpus, BridgeTower Media Newswires

Last year, I wrote an article outlining the biggest mistake I believe investors can make. I argued that investors who lack patience, discipline and the ability to stay the course are effectively challenging their own choices and trying to time markets.

Tying into that, I think that the second biggest mistake an investor can make involves their asset allocation decisions. Asset allocation is the process of balancing risk and reward by putting a portfolio's assets in different types of investments or cash to achieve the investor's goals. One rather widely known study found that asset allocation explained 90 percent of the variability of a fund's return over time with 40 percent of the variation of returns across funds and explained virtually 100 percent of the level of fund returns by Roger Ibbotson and Paul Kaplan.1 There are many theories about how to best achieve the "optimal" portfolio, but doing so is not an exact science. Also, relating back to my previous article, emotion tends to be something that is difficult for investors to put aside when making decisions.

In my experience, asset allocation proficiency is by far the hardest skill to teach with respect to developing an investment professional. I believe that experience, objectivity, intensive analysis, and intellectual curiosity are key in order to develop asset allocation skills.

I've observed in my 50-plus years in the investment community that many investment professionals are taught to analyze similar securities, while often ignoring or not analyzing entire classes of securities because they may represent what is perceived to be a nuanced section of investments or they may be too new to analyze.

I believe that having an experienced, highly educated asset allocator to trust with your financial well-being is just as important as having an experienced, highly educated primary care physician to trust with your physical health.

It may be easier to pick an asset allocator for your investment health than it is a primary care physician. I don't know of any primary care physicians that provide studies on their patient outcomes and only a few specialists that do. However, in my opinion, excellent consultants and investment managers will provide verifiable investment results that can be substantiated. However, if they do not or will not produce results that provide what you are looking for, then I advise not hiring them. I do not believe that investors should make such an important decision based solely on a manager's handpicked referrals. When making this type of decision, I advocate following the concept of "trust, but verify."

To be sure, the investment industry is very complex. Following are a couple of things I believe are key to review before hiring a manager:

Thoroughly review their longer-term total returns after all fees and expenses. Demand performance comparisons that are risk-adjusted, net of all fees and expenses against all similar pools of assets over long time periods of at least 15 to 20 years.

My recommendation is to evaluate performance over at least two market cycles to best determine skill from luck, so in considering that the current bull market is nearly 11 years old, the time period for stock evaluation should be at least 16 years.

If an advisor advocates for frequently changing benchmarks, ask why and question whether that explanation makes sense.

Finally, how has your asset allocator controlled risk, i.e., what is your stock/bond allocation? Bonds, which are debt instruments and offer regular interest payments, tend to be safer than preferred stock, which pays set dividends, and preferreds tend to be safer than stocks, which are ownership instruments. Less seasoned stocks may provide higher returns, but may be more volatile. A good measure of risk is looking at weighted portfolio Beta (a measure of how volatile an investment is compared to the overall market) and standard deviation (which gives context to how volatile an investment has been over a specified time period).

When an investor analyzes the portfolio's returns, net of fees and expenses, they can then determine the added value (alpha). This is what I believe should be compared over longer time periods.

Choosing the right asset allocation mix in my opinion is extremely important to achieving an investor's financial goals. If an investor can maintain a long term perspective and be disciplined to rebalance their portfolio to their chosen asset allocation, I believe they can position themselves for success. If doing so is too difficult to analyze, implement or monitor, investors should then seek help from experienced investment professionals based on some of the criteria that I've outlined above.

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Footnote

1Ibbotson, Roger & Kaplan, Paul. (2001) "Does Asset Allocation Policy Explain 40, 90 or 100 Percent of Performance?" Yale School of Management, Yale School of Management Working Papers. 56.10.2469/faj.v56.n1. 2327

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George W. Karpus is Chief Investment Strategist and Chairman of the Board of Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, NY 14534 (585-586-4680).

Published: Mon, Jan 13, 2020