Have you ever known a compulsive hoarder? They’re people who collect stuff that they can’t bring themselves to sell, even if they have no further use for it.

Hoarders’ wardrobes overflow with clothes they never wear, their shelves sag under the weight of books they never read, their fridges are full of food past its use-by date and their sheds are crammed with junk.

Much hoarding is harmless, and stems from an attachment to a possession whose sentimental associations have outlived its utility. But in the investment world, a reluctance to sell can prove costlier than you imagine.

A study of US investment advisers by AllianceBernstein, found the factor that most frequently causes individual clients to ignore advice on asset allocation is a reluctance to sell winners and buy under-performers.

Fund managers have a similar problem, according to a separate study by UK firm Inalytics, although they tend to hold onto losers for too long and cut winners too early in a knee-jerk response to a short-term sell-off.

In both cases, though, the surveys found individual investors and professional fund managers tend to be better buyers than sellers.

So what do you do? The temptation might be to conclude that these hoarding decisions reflect a failure of market-timing skill. You might also think you can profit from the mistakes of all those sentimentalists out there.

Unfortunately, there is no evidence that it possible to profit consistently from timing the market.

Indeed, the tendency of most unsophisticated investors is to buy high and sell low. They make this mistake because they focus on last year’s returns, rather than their own long-term goals.

Neither can you build a long-term investment strategy out of the fact that many people’s perceptions are not consistent with reality. Studies show a market can still be rational, even if participants are irrational.

But if you accept that markets for the most part work, you realise that speculation is futile.  This means persistent differences in returns are explained by differences in risk.

The next step is to concentrate on the risks that are worth taking and eliminating the risks that don’t offer reliable rewards.

To do this, you need to think of asset classes instead of individual stocks. This is because science has shown that the sources of risk and return in markets come from just five factors – market, size and value characteristics for equities and duration and default risk for fixed interest.

If you hold these asset classes in proportions that fit your risk profile and you view your portfolio as a singular unit rather than a collection of parts, you are less likely to make sentimental decisions about individual components.

Generally, the greater the proportion of stocks in your portfolio, especially small cap and value stocks, the more “aggressive” its risk profile and the greater its expected return. Dimensional takes this scientific approach to its own portfolio management, structuring strategies around compensated risk factors and trading in a disciplined, focused and consistent way.

It uses buy and sell ranges to trade stocks, but does not automatically sell if a stock moves above the buy ceiling. It does this by employing buffer or hold ranges that provide some breathing space. Likewise, it does not automatically offload a stock just because it drops out of the buy range.

Dimensional also takes into account the phenomenon known as “momentum”, which describes the tendency of stocks that have done very well relative to the market to continue to do well, and for stocks that have done poorly to continue to under perform.

The secret here is not to get sentimental about individual stocks. Neither should you get embarrassed about selling “too early”. Instead, focus on capturing the returns of a particular asset class as efficiently as possible.

Sometimes that means selling winners to seek out other stocks where the potential returns are greater.

The lesson for the individual investor in all this is to take a dispassionate and disciplined approach to portfolio rebalancing. This ensures you invest new money according to your stated asset allocation targets and focus more on the big picture of total return than on the individual components.

It’s the perfect cure for the hoarder!

By Jim Parker, Regional Director, DFA Australia Limited.
Jim Parker was formerly a senior editor and financial markets writer with the ‘Australian Financial Review’. DFA Australia Limited is the Australian subsidiary of Dimensional Fund Advisors and is a registered investment manager in Australia and the USA. It also provides investment research reports and insights. 

Tags: investment, Investment strategy