Which is more important, capital allocation or asset selection?
Please think back to what you usually do when you invest. Do you usually think about how much money to put in the bank first, and then how much money to buy bonds and how much money to buy stocks? If you want to buy stocks, do you have to think about choosing one and see what to buy?
Let's look at two words first, one is "capital allocation", which refers to how funds are allocated in large categories of assets, such as how much to deposit in banks, how much to invest in bonds, how much to buy stocks, etc.; the other is "assets "Selection" refers to which specific stocks to buy for a certain type of asset, such as stocks.
In fact, as long as we make investments, we will use these two terms, because all investments face two steps of capital allocation and asset selection.
So here comes the question, which step do you think is more important, capital allocation or asset selection?
Do most people allocate assets based on feeling and patting their heads, but spend a lot of time and energy on which stocks to choose?
In fact, the first step, capital allocation is much more important.
As famous as Buffett, Russell, etc., Gary Brinson, who is known as a living legend in the investment world, once pointed out in a famous cooperative study in 1991:
Capital allocation, that is, how funds are allocated in major categories of assets such as stocks, bonds, and bank deposits, affects more than 90% of total returns!
Most people spend the vast majority of their energy on which stock to choose. In fact, this contributes less than 10% to the total return. And the capital allocation that people make decisions at will is crucial.
Wrong "1/n rule"
When investors conduct capital allocation, they will diversify their investments, knowing that they should not put all their eggs in the same basket, but the general understanding of diversification of investments is too simple, which is not true full diversification, or optimal diversification. It is easy to cause misconfiguration.
Let's start with a test to see where diversification might go wrong, and finally what proper capital allocation means.
If you have a sum of money to invest, here are a few investment options for you:
You can invest all in a money market fund, which is low risk; you can invest all in a bond fund, which is moderately risky; or you can invest partly in each. How do you vote?
You may choose to invest in each part to spread the risk and obtain an average return.
So how to diversify investment? A typical approach is to cast 1/2 each.
Looking at another investment option, which one would you prefer? You can invest all in a bond fund, which is moderately risky; you can invest in a stock fund, which is high risk; or you can invest partly in each. How do you vote?
You might still choose to cast 1/2 each.
As another investment option, you can invest all in a low-risk money market fund, or invest in a high-risk stock fund, or you can invest in a part of each. How do you vote?
You might still vote 1/2 each.
Think about how you allocate your investment funds, is it very close to the above options? Regardless of whether the risk is small-medium, medium-high, or high-low, you will invest 1/2 each.
In 2001, Nobel laureate Richard Thaler and his collaborators conducted a study and found that people want to diversify their investments, but they are simply diversifying.
In the 170 large enterprise annuity investment plans, investors only invested 1/n of each alternative investment, regardless of the investment offered.
· If the optional investment is stock and bond funds, investors will invest 50% each;
· The optional investment is stock type and mixed type (50% invested in stocks, 50% invested in bonds) two funds, investors will still invest 50% each;
· The optional investment is bond type and mixed type, or each investment is 50%.
No matter what choice is given, investors will "play cards" according to 1/n, which is called the "1/n rule".
Note, however, that the difference is actually quite large.
· Under the first option, the proportion of investors’ assets actually invested in stocks is 54%;
· Under the second option, the proportion of investors’ assets actually invested in stocks is 73%;
· Under the third option, the proportion of investors' assets actually invested in stocks is 35%.
The "1/n rule" is not a rational way of allocating capital.
How do rational people allocate assets?
No matter what the options are given, rational investors should be very clear about their risk preferences, and their preferences will not change.
In other words, rational people will accurately calculate the proportion of capital allocation among the above three options, and finally invest in a certain risk asset.
For example, the proportion of stocks is the same in all three cases. If for this person, the optimal proportion of investing in stocks is 40%, then no matter which alternative assets are given, the proportion of this person's final investment in stocks should be 40%.
Therefore, the simple way of diversifying investment such as the "1/n rule" is different from rational and precise diversification. Simple decentralization and misuse of capital allocation are mistakes that cannot be ignored for investment decisions.
So, how should rational decentralization be done?
In fact, the ratio of rational diversification or optimal capital allocation can be precisely measured.
Everyone's optimal capital allocation should maximize their own utility. The utility value depends on three variables: the return on the asset, the risk on the asset, and your own risk preference.
That is to say, in the face of the same assets, each person's optimal capital allocation ratio depends on each person's risk preference, and rational people calculate the most suitable allocation ratio according to their own risk preference.
For example, A may be more afraid of risks, so the calculated optimal capital allocation of A may be to invest 62.7% of funds in banks and 37.3% in stocks. But B is not so afraid of risks. The calculated optimal capital allocation of B is to invest 36.4% of funds in banks and 63.6% in stocks.
A and B have different capital allocations due to their different risk preferences. But everyone has a certain risk preference, so for everyone, the optimal capital allocation is certain.
Let me emphasize again that the "1/n rule" of simple decentralization and head-scratching decision-making is not a rational capital allocation, and capital allocation is the most important factor affecting our investment returns.
Are you overtrading?
Have you noticed a phenomenon: Individual investors in the financial market lose more, while institutional investors lose less?
In fact, this has been an intuition of everyone for a long time, but few people have provided definite evidence, and they are not too clear about the main reasons why individual investors are prone to losses.
It wasn't until 2000 that the mystery was solved for the first time.
Two scholars from the University of Chicago, Barber and O'Dean, obtained the transaction data of 35,000 individual investors from a large US brokerage firm. They found that if transaction costs were considered, the returns of individual investors were much lower than those of the market.
The two scholars sorted by monthly turnover rate and divided investors into 5 equal parts. They found that no matter what the turnover rate was, the total income of investors was similar.
"Turnover rate" is also called "turnover rate", which refers to the frequency of stocks changing hands within a certain period of time.
Stock turnover will increase transaction costs, so the higher the turnover rate group, the lower the investor's net income (net income is total income minus transaction costs).
What this statistical result reveals is that the main reason for the loss of individual investors is that there are too many transactions!
Many people think they are familiar with certain stocks, and they will do the same stock repeatedly, buy and then sell, sell and then buy, over and over again.
What this large-sample research wants to show is that no matter how frequently you trade, the total return is similar to buying and holding, but it will consume transaction costs.
This phenomenon is a common trading feature of individual investors, whether it is abroad or at home.
Relative to the rational trading frequency, investors are overtrading, which is the theory of overtrading.
What would investors do if their investment behavior was rational?
They will invest at fundamental value. Changes in fundamental value are rare, so rational investors should trade infrequently. If everyone is rational, then I should not be willing to buy when you are willing to sell.
In fact, in most exchanges in the world, the frequency of transactions is much higher than that achieved by rational principles. This is true for both institutional investors and individual investors, but individual investors trade more frequently.
The behavioral finance explanation for investor overtrading is:
Investors believe they have enough information to trade. In reality, this information is not enough to support any transaction. Investors with higher levels of overconfidence will trade more frequently, but because of transaction costs, the returns will be worse.
Who is more likely to overtrade?
Why can't investors always resist overtrading?
This behavior is mainly due to a cognitive bias we talked about in the previous article-overconfidence. Overconfident people believe too much in their own judgment and are more likely to buy or sell impulsively, resulting in excessive trading frequency.
So what kind of person is more likely to over-trade because of overconfidence?
| Gender Impact
Gender was a significant factor, the study found.
Barber and Odeen, the proponents of the over-trading theory mentioned above, published a famous article on gender, overconfidence and stock investment in the top economics journal QJE in 2001. The main title is "Boys will be boys” (boys are boys).
It means that boys are naughty, more active, and more overconfident than girls, so their trading frequency is higher. On average, men trade 45% more than women. Excessive trading reduces net income by 2.65% per year for men and 1.72% for women.
When the sample was subdivided, single men traded more frequently and lost more money than single women. Single men traded 67% more often than single women, making them 1.44% less profitable than single women.
Not only this study pointed out that women's risk preferences tend to be conservative, and their irrational trading behavior is less than that of men.
On August 4, 2014, the Wall Street Journal also reported that some funds invest exclusively in companies with female leaders. These funds argue that companies with female leaders tend to outperform those that lack female leaders.
For example, the "Women Leaders Total Return Index" fund launched by Barclays is one of them. It only invests in US companies with at least 25% female CEOs or board members.
Investing in women-managed financial firms benefits even more. In early 2013, a report by Rothstein Kass accounting firm pointed out that during the period from January 2012 to September 2012, the index composed of 67 hedge funds managed by women had a return rate of 8.95%, far exceeding that of all hedge funds. The resulting index returns 2.69%.
The final sentence of the report was the highlight: Women-led firms and hedge funds beat their rivals by a landslide.
In 2013, JFE, the top journal of finance, also published a very influential and cited article, which revealed that female executives make investment and financing decisions differently from male executives, and men are more overconfident than women , men will initiate more acquisitions and borrow more due to overconfidence.
This is the main reason why companies managed by male CEOs perform worse than female CEOs.
| Rationality influence
In addition to gender affecting overtrading, what other groups are more likely to overtrade? Less rational people overtrade more than rational people. It is generally believed that individual investors are less rational than institutional investors, and overtrading is more serious.
Therefore, if a company's investor structure is dominated by individual investors, the transaction volume or turnover rate caused by excessive trading will be particularly high.
How to avoid overtrading?
So what kind of trading frequency is appropriate, and how can we avoid excessive trading?
We need to pay attention to some factors that will affect the frequency of transactions.
Barber and O'Dean's research found that the transaction method will affect the transaction frequency, and the more convenient transaction method will make the transaction more frequent.
For example, online transactions, programmatic transactions, etc.
Zingales, chairman of the American Finance Annual Conference, also pointed out that the circle of friends will also affect the frequency of transactions. People's investment will be affected by the environment. If the frequency of transactions of people around you increases, your transaction frequency will also increase. Effective way to trade frequency.
In 2015, a study in JF, a top journal of finance, also revealed an interesting discovery called the neighbor effect, which means that even a highly rational person like a fund manager will be affected by the behavior of his colleagues who live nearby. This reveals the existence of social effects and community effects.
In addition, the theory of overconfidence reveals that the more experienced people are, the more serious their overconfidence is. Therefore, the more experienced people are, the more they need to pay attention to the possibility of over-trading.
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