Avoiding Forced Irrationality

If you really want to find a scapegoat for volatility or losses in your portfolio, you don’t have to look very far. The financial media and investors who lack self-awareness are very quick to point a finger after seeing their holdings fall for a number of reasons — high frequency trading, the Fed, risk parity, passive indexing, mom & pop investors, the shadow banking system, tax loss harvesting, junk bonds, increased market correlations, risk on/risk off, short-sellers and the list could go on.

The latest culprit, according to many, is exchange-traded funds, specifically of the bond variety. Earlier this week Matt Hougan over at ETF.com had a very thorough write-up on why the worries about fixed income ETFs appear to be much ado about nothing:

People have gotten all up-in-arms about this, worried that the discounts in ETFs expose some sort of problem with bond ETFs. In reality, all those discounts say is that the stated NAV is baloney, and the real clearing price for the bonds is lower.

The beauty of the ETF is that, because all the redemptions are in-kind, shareholders who don’t sell are protected from any harm by those that do. And eventually, when markets normalize, the ETF trades back to its stated NAV and everyone goes on their merry way.

The issue at hand here is that there is the potential for these ETFs to trade either above or below their stated net asset value because many individual bonds can be fairly illiquid. This could be a problem because ETFs trade throughout the day at market prices. At the extremes this could lead to some severe dislocations between the market price and the value of the underlying holdings if investors decide to rush to the exits all at once.

In my mind, this entire debate is a case of not being able to see the forest for the trees. Before worrying about the structural differences between ETFs and mutual funds investors should figure out how to never put themselves in the position of panic selling in the first place.

Investors don’t need ETFs to act irrationally and cause volatile prices. They’ve been doing that just fine on their own for as long as tradable markets have been in existence. If you wish to make money over time, you’re never going to be able to avoid risk. What you really want to avoid is making a huge mistake with risky assets at the wrong time.

I like to look for ways to avoid forced irrationality. Here are a few ways in which investors can be forced into making an irrational decision with their portfolio:

Not having enough high quality sources of short-term liquidity for spending needs. This one should be easily apparent, but when the fear of missing out sets in, investors tend to forget about the importance of their liquidity needs. This was a huge problem for some of the largest, most sophisticated pools of capital in the 2008 blow-up. You never want to put yourself in the position of being forced to sell an asset after it’s already taken a huge tumble because you didn’t set aside enough cash-like instruments to get you through some market turbulence.

Not having a portfolio in place that matches your risk profile and various time horizons. Again, this one is fairly simple, yet investors are constantly changing their portfolio holdings based on the market’s movements, not their own unique situation or goals. Striking a perfect balance between your need, desire and ability to take risk is not an easy task, but this is usually where most investors go wrong when making short-term decisions with long-term capital. If you don’t know yourself as an investor, there’s no way you can tell how you’ll react under stressful situations with your portfolio at stake.

Chasing yield. Want a higher yield? You’ll likely have to endure periodic losses and more price fluctuations. Want to avoid severe price fluctuations? You’ll likely have to endure a lower yield. Chasing yield after prices have risen is generally a terrible strategy, yet one that investors make on a consistent basis at the wrong point in the cycle.

Career risk. Why do so many professional investors, who mostly know better, partake in irrational moves such as window dressing, performance chasing, closet indexing and shorter-ism? In short, career risk. Every day there are terrible decisions being made in the markets by people who are trying to please others to keep their own job. This is a huge source of market inefficiency and forced irrationality, even though it’s mostly self-inflicted.

Leverage. Leverage tends to amplify moves in both directions, but it really makes things more painful on the downside when you’re forced sell to meet margin calls.

Having no plan in place. Investors with no plan at all practice a form of continual irrationality because it’s only a matter of time before a huge mistake takes place. Following a plan is never easy, but one of the biggest mistakes I see with investors is that they don’t have a process or set of guidelines to guide their actions when the markets go against them.

It’s much more difficult than people realize to ignore the herd mentality because (a) sometimes the herd is right and (b) even when they’re wrong it’s much more comfortable to go with the safety in numbers syndrome.

The best investors understand how to minimize their own irrationality and take advantage of the irrationality of others.

ETFs Solve Mutual Bond Fund Problem (ETF.com)

Further Reading:
Liquidity Risk: Same As It Ever Was



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