What Do Risk Preferences Reveal For Asset Allocation Decisions? A Lot.

Managing risk is forever at the top of the list for informed investing, but the biggest challenge on this front arises from within. As Pogo famously said, “We have met the enemy and he is us.”

So-called behavioral risk comes to mind after reading a recent survey of risk preferences, which reminds that investor perception on risk casts a long shadow on choices for asset allocation and, by extension, portfolio returns. Perhaps the most surprising result is that individual investors tend to think about risk is starkly different terms vs. financial advisors and institutional investors. Not surprisingly, these preferences have real-world results.

“Each of these groups has its own risk preferences and behavioral characteristics that guide investment decisions,” notes “Measuring Risk Preferences and Asset-Allocation Decisions: A Global Survey Analysis,” a recent study by Andrew Lo (a finance professor at MIT) and two co-authors. The results are based on polling more than 22,000 individuals, nearly 5,000 advisors, and 2,000-plus institutional investors for the three years through 2017. The “goal is to understand how different market participants and different types of individuals compare along the dimensions of risk aversion and asset allocation,” Lo and company explain.

One of the key findings: “we find that most financial advisors and institutional investors employ a contrarian allocation strategy — that is, they change equity allocation in the direction opposite to recent returns on the S&P 500.” Those preferences diverge against “the overall behavior of individual investors, who on average are extrapolators.” In other words, individual investors tend to use past performance as a forecast for thinking about equity market allocations.

The past isn’t irrelevant, of course. In fact, sometimes it deserves to be the dominant factor for developing expected returns. But not always. In addition, the lens you employ to study the past is also important. Valuations and other non-performance metrics can be more valuable at times vs. returns.

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DISCLOSURES:  

PLEASE REMEMBER THAT PAST PERFORMANCE MAY NOT BE INDICATIVE OF FUTURE RESULTS.DIFFERENT TYPES OF INVESTMENTS INVOLVE VARYING DEGREES OF RISK, AND THERE CAN BE NO ...

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