Question

Identifies how a client’s biases, preconceptions and assumptions influenced your portfolio management strategy

Answer 1

Here first let me tell the four most common client biases that influence portfolio management

1) Disposition Effect Bias: This refers to a tendency to label investments as winners or losers. Disposition effect bias can lead an investor to hang onto an investment that no longer has any upside or sell a winning investment too early to make up for previous losses. This is harmful because it can increase Capital gain taxes and can reduce returns even before taxes.

2) Hindsight Bias: Another common perception bias is hindsight bias, which leads an investor to believe after the fact that the onset of a past event was predictable and completely obvious whereas, in fact, the event could not have been reasonably predicted.

3) Familiarity Bias: This occurs when investors have a preference for familiar or well-known investments despite the seemingly obvious gains from diversification. The investor may feel anxiety when diversifying investments between well known domestic securities and lesser known international securities, as well as between both familiar and unfamiliar stocks and bonds that are outside of his or her comfort zone. This can lead to suboptimal portfolios with a greater a risk of losses.

4) Worry: The act of worrying is a natural — and common — human emotion. Worry evokes memories and creates visions of possible future scenarios that alter an investor’s judgment about personal finances. Anxiety about an investment increases its perceived risk and lowers the level of risk tolerance. To avoid this bias, investors should match their level of risk tolerance with an appropriate asset allocation strategy.

Now let me discuss the preconceptions and assumptions

The biggest trouble with market assumptions is that if everyone makes them, they might already be completely discounted. As a result, what you are concerned about may indeed be a real worry, but, ultimately, might not have any actual impact on stocks if the market has already correctly adjusted for it.

For example, hundreds of experts back in 2008 were predicting the end of the financial world. They just assumed a complete financial collapse was coming. But at one point in the crisis more than 1,000 companies were trading below their net cash position. Even in a meltdown, these companies’ stocks might have still gone up. As it happened, these companies soared since there wasn’t a collapse.

That’s how it goes with assumptions so let’s look at five common assumptions in the market right now, which will hopefully cause investors to reflect on whether they should do anything about them in their portfolios.

There are 5 basics assumptions and preconceptions that are:

1)

Rising interest rates

Everyone now more or less assumes interest rates are going to increase. How could they not since U.S. Federal Reserve stimulus has kept rates artificially low for a long time?

But remember: There is no rule that states rates must rise. In weak economic conditions and low inflation, rates could stay low for decades.

All those investors who panicked this summer and sold their fixed-income securities need to stop and think, “Has the market priced in more rate increases than will actually happen?” If so, fixed-income stocks might still go up, even on small rate hikes.

2)

Rotten Septembers

Everyone knows September is the worst month for stocks so lots of investors try to preempt the month’s decline by going to cash.

Except the market so far this month has done remarkably well. At the time of writing, the Dow Jones was up 700 points in September; and the TSX was up almost 200 points. Again, maybe the common assumption was already well priced into valuations.

3)

Slower earnings

Most investors assume earnings growth is going to slow down. How can companies, they ask, continue to reduce costs and drive up profit margins year after year?

Well, maybe they can because of technology. Companies keep spending to speed up production and make workers more effective. That’s one reason why so few jobs are being created — bad for the unemployed, yes, but great for company profits.

We certainly don’t think anyone should assume neither technology improvements nor company greed for more profit are going to stop anytime soon.

4)

Recovering junior gold stocks

Many investors, still hanging on to their junior gold companies, are assuming the sector has to recover one of these days. We kind of assume the same thing since the sector has been ugly for years now. Again, though, there are no rules that say the gold sector has to improve any time soon.

Certainly, in the short term, having stocks down 75% this year will likely just result in more selling in the sector. The stocks could go up or down, but, for the sake of your portfolio, you should not assume one is going to happen over the other.

?5)

Hot IPOs will surge

All the buzz now is on the upcoming Twitter IPO. Like Facebook, everyone just assumes it will be a killer IPO. As Facebook learned, though, the greater the hype, the greater the assumptions, and the bigger the fall. Analysts who called Facebook a “sure thing” looked pretty bad when its stock fell to less than half its issue price.

We have already had clients asking how they can get a piece of the Twitter IPO. They are assuming it will go up even before the valuation on the deal has been released. That is way too much of an assumption.

In general, assuming things often gets you into trouble — whether it concerns your life, the weather, your relationships or the market. Keep that in mind the next time you are sure a stock is going to go up.