Behavioral Finance: Are your investments a picture of health?

"A well-diversified portfolio is similar to a core diet of fruits and vegetables that potentially offers healthy returns while reducing investment risk."

Behavioral Finance: Are your investments a picture of health?

Some people invest the same way they eat–overindulging on an array of instruments that excite them. However, this approach may not give investors a well-balanced portfolio that optimizes risk and returns. Eric Tang explains how a well-diversified investment appetite can help investors achieve better results.
Eric Tang  
Head, Distribution Management Hong Kong
Investment Products & Services, UBS Wealth Management

Many investors focus on looking at their most attractive investment instruments on a standalone basis. They cannot see the wood for the trees, as they are happy with little investment victories without realizing that their overall portfolio has barely moved. This is similar to the short-lived sugar highs that people get when they indulge in a chocolate bar: gratifying in the short term, but probably not healthy in the long run.

At UBS, an investment committee led by UBS Wealth Management Global Chief Investment Officer Mark Haefele meets regularly to discuss and decide on asset allocation, taking into consideration the latest economic and political developments around the world.

This is crucial because many studies have shown that, on average, a well-diversified portfolio outperforms those that are overly concentrated on a risk-adjusted basis. As we know, investors who hold individual stocks or bonds are exposed to several different risks, including company risk, sector risk, and market risk. A well-diversified portfolio helps to mitigate the first two, leaving market risk, which is unavoidable unless one chooses not to invest at all.

"Do not chase the high"–but where is the high?

Investing may sound simple in principle: buy low and sell high. Yet, who can tell with certainty when stocks have reached a ‘low’, or when they have hit a ‘high’?

For example, it was common last year to hear investors complain about how ‘high’ the S&P 500 index was at that time. An investor who entered the US equity market in June would seem to be buying at a record ‘high’. Yet with US equities continuing to rise, the investor would have been able to pocket another 15% or more in the second half of the year.

The same thing is happening in Europe this year. Our Chief Investment Office (CIO) upgraded its Eurozone equity allocation to overweight last year. The STOXX Europe 600 index returned more than 17% in 2013, but again, many investors are choosing to wait and see if the region continues to recover. With various indicators showing that the Eurozone is back in business, how many will miss a potential opportunity once again?

The above examples demonstrate that timing the market is never the best strategy–there is hardly a perfect time to invest. Instead, investors can benefit more from focusing on their long-term strategy, by making changes to their asset allocation in response to business cycles and momentum trends.

If there is one behavior that matters, it is discipline

How often have we planned to sell a particular stock when it rises 10%, only to hold on to it when it does hit the target? It is normal human behavior to always want more, which makes it difficult to sell when markets are rising, and cut losses when they are falling.

To prevent making emotional investment decisions, we can employ a professional portfolio manager to inject discipline into our portfolio. A portfolio manager will make investment decisions within the pre-agreed mandate, and be required as part of the investment process to pocket profits or cut losses when the security has reached the target price. At UBS Wealth Management, our portfolio managers follow our CIO’s strategies, implementing changes to the tactical asset allocation in a timely and disciplined manner.

Discipline does not only apply to individual securities trading, but also to the overall asset allocation of our portfolio. Many investors choose to put their money in markets closer to home, regardless of performance. A mandate with diversity in geography and asset classes can help balance home-bias, while capturing opportunities globally.

Investments should start with understanding one’s own profile

Before embarking on an investment journey, one needs to understand his or her own personality and goals– the chosen investment strategy should reflect the investor’s profile. An investor with a lower risk tolerance can choose an asset allocation that is more heavily weighted towards fixed income instruments, to benefit from a continuous income stream. Similarly, an investor with a higher risk appetite who is able to ride out volatility can pick an asset allocation that is more heavily weighted towards equities. Other than equities and bonds, hedge funds can serve as a portfolio diversifier by investing in certain non-traditional markets.