By Roger Nusbaum, AdvisorShares ETF Strategist
Barron’s knocked it out of the park this week with several articles including two in particular; Invest Like Mr. Spock, Not Homer Simpson which was an interview with Richard Thaler about behavioral finance and an article which had some interesting insight on what many in the industry are now calling liquid alternatives or diversifiers as we have referred to them in past blog posts.
The Thaler interview had plenty of useful nuggets but at a higher level an important takeaway is not just reading about these sorts of mistakes but having the self-awareness to understand the ones you are most vulnerable to or if you’re an advisor which ones your clients are most vulnerable to.
Thaler starts out with a bit of a zinger;
The world I study is full of people more like Homer Simpson—a little chubby, with a poor memory; who has trouble with long division, much less determining the present value of a stock.
Beyond that the starting point of his comments focused on the basics of simply saving enough money and the role overconfidence might have played in the housing crisis. He then goes on to discuss investors’ tendency to sell after large declines and buy after large rallies.
Interestingly he noted the disposition effect which he said is the tendency to sell too early although a couple of weeks ago in another issue of the magazine was “Baron Rothschild when asked about the secret of his great wealth, he said he sold too soon.”
The article on liquid alternatives had two points in particular worth mentioning that tie in with each other. The article offered some generic sizing ideas of 3-15% of a portfolio devoted to alternatives. This is something we’ve talked about before. I tend to believe in moderate exposure although increasing exposure as part of a defensive strategy is typically how I have approached the space.
There is a behavioral component to allocating to alternatives which tying in to Thaler above is that people have little to no use for alternatives when the market is rallying and then talk about putting too much into them after a market decline. I’ve mentioned many times before the comment that was left on a Seeking Alpha post of mine during the bear market where the commenter said it would make sense to put it all into Hussman and not worry about it. This was of course a bad idea (if the reader was serious) as equities have gone up most of the time and doing as the reader implied would be a colossal bet on a somewhat narrow strategy regardless of Hussman’s results.
The other point to mention from the alts piece is the extent to which advisors are starting to use them as substitutes for fixed income exposure. As has been the case for years, there are many parts of the bond market that are expensive and while assets can remain expensive for a very long time it is prudent to avoid loading up on expensive assets. The key to this point is that while there may be some alternative strategies with volatility profiles similar to bonds (when bonds aren’t expensive) there are some alternatives that are plenty volatile.
Obviously the key is truly understanding the strategy. If you want to shy away from bonds due to interest rate risk then it doesn’t make sense to allocate into an alternative strategy that is vulnerable to rising rates.