Financial Reference

Recently, even after a large increase in international stock and commodity prices, a strange thing is happening: people are being encouraged to buy more. Even people who believe the sector is “fairly valued” (read “over-valued”) are buying more because of the diversification benefits of these investments.

It is usually the case when one asset class has a large run-up in price, the asset class should be re-examined and possibly partially sold. This is due to a couple factors. First, it might be sold because the asset class is more over-valued relative to other asset classes. Second, it might be partially sold to rebalance the portfolio.

But after the run-up in the prices of international stocks and commodities, Americans still don’t have enough invested in these assets, according to some analysts. While I agree with the basic sentiment — there are diversification benefits of investing in these asset classes — I believe that much of this diversification benefit is going to be overblown for the following two reasons.

First, international stocks and domestic stocks are becoming more correlated and are more correlated in times of panic. It makes sense that the correlation is increasing: (1) our economies are becoming more integrated in an increasingly globalized world and (2) domestic companies own significant foreign assets. Also, historically the time at which diversification is most useful — when markets are in crisis — have seen higher correlation (and hence lower benefits).

Second, I believe investors are buying these assets for the wrong reasons and so are more likely to sell than if they were buying for the diversification benefits. While investors and planners claim they are increasing their allocations due to the benefits of diversification, I believe the most important reasons for the increased allocation are recent performance and, possibly, a belief in a weak dollar and higher inflation. Investors have always had the opportunity to increase ther exposure to these assets but have only chosen to very recently.

Investors who buy for the diversification benefit are more likely to stick around, even when markets decrease. Investors who buy in order to increase returns are speculating and will be more likely to sell when these markets naturally fluctuate. While, overall, investors should increase their allocation to foreign assets, the motivation of the investor is more important than the actual allocation in determining performance.

The main role of financial advisors, as I see it, is to provide an unemotional reality check to investors. Most people have or can develop the knowledge necessary to manage their finances. It would take some time, but not much more than mowing the grass each week. The hardest part of managing your finances is to remain unemotional about your investments. A second, unemotional, opinion can help.

Planners can protect people from themselves. It is well documented that investors make sub-optimal decisions. They chase performance, sell after market declines, hold on to investments to try to break even, and use heurisics to analyze their portfolio; just to name a few problems. (For more see Psychology of Investing.) Planners can help investors be disciplined in their actions.

Planners can provide target asset allocations and rebalancing discipline; they can stop investors from trading too much, from trying to chase performance. They can also provide comfort by giving the investor financial projections.

Even for knowledgable investors, financial planners can provide value by providing piece of mind and by forcing investors to maintain discipline.