Q&A talks with Brian Portnoy, a recognized expert on behavioral finance and alternative investments and the author of the recently-published book “The Investor’s Paradox: The Power of Simplicity in a World of Overwhelming Choice.” He was recently hired by Hartford’s Virtus Investment Partners as vice president and director of investment education.
Q: What is behavioral finance? Explain what it hopes to accomplish and how it helps individual investors not make irrational decisions.
A: Behavioral finance applies the basic insights of psychology to investing. Rather than assume all people are “rational,” it starts with the premise that individuals are hard-wired with cognitive and emotional biases that make the investing game hard to win. One of the most profound insights in recent years is the so-called “behavior gap,” which demonstrates that what a fund returns and what an investor earns can be quite different.
Take the Vanguard S&P 500 Index Fund. Over the past 15 years through the end of 2014, the fund’s annualized return was 4.1 percent. But taking into account when investors contributed to or withdrew money from the fund, the average “investor return” was just 1.3 percent.
Investors earned less than half of the index’s returns. Because we tend to buy high and sell low, which is directly a function of our emotions overriding good decision making, investors tend to underperform their own investments. It’s a troubling phenomenon. Studying behavioral finance can help us address some of these decision-making shortcomings.
Q: Your book, you say, provides simple, time-tested approaches for advisors, institutions, and individuals to evaluate countless investment options and navigate volatile markets. How does that jibe with your experience as an expert in alternative investments?
A: I’ve been very fortunate in my career to do research on the entire spectrum of fund investments, ranging from relatively straightforward index funds to highly complex strategies. One thing that experience has taught me is that there are ways to find simplicity in a world of overwhelming choice.
One way to do that is to ask just a handful of straightforward questions about any investment: Is the manager trustworthy? What risks does he or she take, and is she skillful at doing so? And how might their strategy fit into my own portfolio, if at all?
With those questions, you can cut quickly to the merits of any individual choice, even when dealing with the more complex. Getting sucked into the intricate details is a sure way to lose the forest for the trees.
Q: The book also addresses the false dichotomy between “traditional” and “alternative” investments. What is that dichotomy and how should investors address it?
A: The human mind is wired to put everything we see in categories, often with artificially stark boundaries between them. The investment world, for example, tends to distinguish between “simple” mutual funds and “complex” hedge funds. But being practical, those two buckets obscure more than they reveal.
Instead, it’s more productive to think about a spectrum of managers based on the constraints that bind their portfolios. Some portfolios are designed to give narrow exposure to a particular market with little wiggle room. Others have free reign to go anywhere. No point on the spectrum is either good or bad in theory. It’s all about what’s right for your own portfolio.
Q: One endorsement of your book describes it as a great text on picking fund managers. What is the best way to pick a fund manager?
A: Sound investing starts by looking in the mirror and asking: What am I trying to achieve? Any investment decisions that are made independent of a well-articulated long-term financial plan (which includes both a budget and a sense of long-term liabilities) are unlikely to prove fruitful.
I strongly advise investors not to try to “beat the market” because, at the end of the day, that is a game that is not tied to your goals.
Thus good fund managers are those that have a good chance at helping your overall portfolio meet your financial objectives — no more, no less. Investing actually is supposed to be kind of boring. If you find it exciting, you’re probably taking too much risk.
Q: Your job title includes director of investment education. Is this a new trend in your field? How has investor education been handled in the past in a general sense? And how is it changing going forward?
A: My philosophy on investing boils down to just this: Well managed expectations produce investment success. That relates to any individual choice you make, as well as your portfolio overall. Having realistic aspirations for one’s finances is critical, because when outcomes don’t meet expectations it’s very disappointing.
The rub is that managing expectations in this field is quite difficult due precisely to the behavioral quirks mentioned above. There has always been some level of investor education in the industry, centering around a few key ideas like diversification.
That’s good, but given both the powerful insights of behavioral finance and the overwhelming complexity of investors’ current choice set, the opportunity for insightful expectations management is enormous. And that’s what I’ll be working on.
