Most investors do not prioritize asset allocation as the most important aspect of their portfolio decision-making process. For them, asset allocation is what results after a series of security selection decisions. Other investors may prioritize asset allocation a bit higher, but are constantly changing it in an attempt to take advantage of the next trend in security popularity. The cognitive investor’s process starts with a fixed asset allocation that drives security selection and market timing decisions. This is a fundamentally different mental model, and it forces the investor to focus on answering a completely different set of questions from those addressed by the conventional media or the purveyors of most financial products and services.
Why is a fixed asset allocation important? An ever-changing and unmonitored asset allocation can be very dangerous for the health of the portfolio and the wealth of the investor. The portfolio will likely be overexposed to the worst performing sectors at key market turning points. This can result from either chasing the most recent winners, such as by buying the best performing mutual funds over the last several years, or from neglect, when outperforming sectors start dominating the portfolio because the portfolio is never rebalanced. In the first case, investors’ actions drive the portfolio out of balance. In the second case, external market movements drive the portfolio out of balance. In both cases, when the market direction changes, it is very likely that the portfolio has its highest allocation to one of the worst performing sectors and a very low allocation to the best performing sector. This misallocation is a performance destroyer.
The more typical approach focuses on individual security decisions, such as how should I invest my Roth IRA contribution, or what stock should I buy next, or what changes do I make in my portfolio to protect myself from a rise in interest rates. The cognitive investor has no need to ask such questions. She adheres to a repeatable, explainable, and logical process that does most of the work, once it is solidly established. Additions to the portfolio are invested in the category that is the largest amount lower than its target allocation. Subtractions from the portfolio are made from the sector that is the largest amount above its target allocation. The typical investment approach is a bottoms-up approach. The cognitive investing approach is top-down. The cognitive investor asks herself before any investment: how does this proposed investment affect my asset allocation? Does it move my allocation closer to its fixed target or further away? The focus on asset allocation forces the cognitive investor to focus the most time and effort on developing and maintaining an appropriate allocation. This is where the emphasis should be, since asset allocation decisions are far more important in determining portfolio performance than either market timing decisions or security selection decisions.
An analogy might be helpful to explain this concept more completely. Let’s go to a casino. The typical (non-cognitive) investor views the task of investing as a series of discrete events. The investor “bets” on various stocks or other securities and is rewarded if his choices turn out to be better than the average investor’s choices or that of the overall market. The primary focus is on what securities to buy or sell. The media reinforce this mental model by focusing on the most recent best performing stock groups, writing articles about which mutual funds to buy now, forecasting interest rates, or debating whether Apple stock is a buy or sell. The time frame is invariably the present or the very near-term future. Successfully identify the next trend before others do and your profits are assured.
This typical investor is looking for an “edge” to slant the odds in his favor. The process of making an investment is similar to betting on the roulette wheel or a game of blackjack. He makes a bet and waits to see if he wins or loses that spin of the roulette wheel or hand of cards. Over the longer course, he hopes that he has more winning bets than losing ones. Maybe he will wander over to the poker table and take advantage of other gamblers who don’t know how to play poker as well as he does.
So what is the problem with this approach? The mental model is an oversimplification of a more complex situation. What is deleted in the simplification process is crucial. In a game of chance at a casino, once you make a bet, you can’t change or adjust the bet until the next round. There is a definitive end to the wager, and it quickly becomes clear who won and who lost. In the investing world, you can bet any amount at any time. You can keep making additional bets or subtract from your original bet along the way. There rarely is a definitive end point when the winners and losers are identified. A mental model that does not accurately reflect the underlying situation is bound to cause problems. And that is what happens to those who treat the task of investing as a series of discrete events. Since it is never clear when the game is over, the investor is subject to all sorts of psychological biases that usually lead to poor outcomes. He is unsure of how to proceed when subsequent events were not anticipated and the price of what he purchased fluctuates. If he looks to peers for guidance, he is subject to herding effects. If he assumes he is smarter than average, he might attribute all of his successes to his own brilliance, but attribute his failures to unforeseeable events out of his control, and never learn how to improve his process. He is swayed by fear, greed, pride, and regret, and the decisions he makes as a result of these emotions are usually the opposite of what they should be. He fixates on irrelevant numbers such as the price he originally paid for a security or its all-time highs or lows. He draws conclusions from insufficient data and links effects with dubious causes, never probing the validity of his assumptions.
What is needed is a better mental model. Let’s take the casino analogy and turn it around. What does the world look like from the perspective of the casino? The casino is not concerned about beating the odds. It does not care what happens with any single or small set of events. It cares about the process. As long as many different gamblers engage in many different games, it will come out ahead because the odds are stacked in its favor. The casino’s task is to make sure that many gamblers are playing games. The mathematics of probabilities will take care of the rest.
So instead of viewing the task of investing as a series of discrete events, the cognitive investor is better served by using a different mental model: that of a continuous process. This more accurately reflects the underlying reality in that there are essentially an infinite number of investment choices when timing and the amount to invest are considered. One should focus on what really matters and what one can control. Choosing which security to buy or sell makes much less difference than deciding how much to invest along the way. The time perspective should be broadened to include the relevant time frame for the individual investor, not the compensation period of a fund’s management. Most likely, “now” is not the best time to be buying or selling most securities, even though it gets the most attention. A process orientation leads the investor to ask a completely different set of questions and pay attention to what is really important for long-term success. What are the limits of our knowledge? How much attention should we pay to forecasts and prognostications about the future? What can we do to reduce the psychological biases that affect all of us?
Perhaps the most important question is: which approach is more likely be successful, that of the gambler or that of the casino? It’s your money and it’s your choice.
Cognitive Investing 