The past 18 months have challenged traditional thinking about investing and asset allocation, diversification, and correlation. For individual investors, risk tolerances have been tested, investment assumptions have been overturned, and fundamental truisms have been questioned. This article describes how some high-net-worth investors have changed their thinking.

In psychology, fight-or-flight is the theory that the sympathetic nervous system biologically reacts to threats by priming us to fight or flee — or, in some cases, freeze! In investing, how do these instincts play out when we make decisions about investment strategy?

Perhaps the most overt link between psychology and investing can be seen in the emotions and behaviors that fuel market bubbles. In the face of outsized returns and new and exciting opportunities, an investor may find that sitting on the sidelines is difficult. Faced with the threat of missing out on the upside, many investors choose to stay and fight — all the while thinking, “This time it’s different.” 

On the way down, however, investors are more likely to have the urge to flee. In the summer of 2008, 44 percent of Institute for Private Investors (IPI) members began raising cash; by autumn, nearly 6 out of every 10 respondents reported an 11 percent or higher cash position.

But the Rules Keep Changing!
In behavioral economics, a decision maker’s preferences are known to change over time, and economic researchers have found that acting on our current preferences is easier even if we know the outcome may not be optimal.¹ For investors, this finding would explain why getting caught up in the euphoria of a market bubble is easier than pulling back even if we know instinctively that the latter course might be more prudent. As one investor put it, “Rearview-mirror investing is always easier than looking forward. It’s tough to pull the trigger even when you recognize signs of euphoria.”

According to 62 percent of IPI members responding to the May 2009 survey, “Fight or Flight (or Freeze),”² one approach to encouraging restraint is to have a formal, written investment policy or allocation guidelines for the entire portfolio. In the same way that Odysseus tied himself to the mast of his ship to prevent his responding irrationally to the sirens’ songs, an investment policy statement helps some investors commit to a disciplined investment plan so that their decisions are less likely to be swayed by emotion. Of the 37 percent of respondents whose overall portfolio does not currently fall within their allocation guidelines, almost three-quarters are diligently rebalancing or planning to rebalance in the next couple of months.

The trouble with investment policies, however, is that the rules keep changing. Of the 62 percent of respondents who do have a formal, written policy, more than half are currently making changes (or considering changes) to their policy in light of their 2008 experience. This finding mirrors IPI members’ actions in 2003, when 49 percent changed their investment policy in response to the bear markets.³

Interestingly, only 15 percent of the respondents have a “stop-loss” provision (a percentage decline that triggers a review) in their formal (or informal) investment policy.

All Other Things Being Equal
Adding to the confusion is the fact that everything seems to be changing at the same time. The models that most investors and advisers use to inform their investment decisions are built on the ceteris paribus assumption that intentionally simplifies complex relationships between variables. If our model is no longer working, how do we know which assumption(s) to change?

Asked what assumptions, if any, they are changing in their own (or their advisers’) forecasting models, 84 percent of respondents reported making a change to at least one input and just over a third have changed five or more assumptions. 

Changes in assumptions about equity returns were the most prevalent, with 63 percent of respondents signaling a change in that area. Specifically, respondents, on average, reported using 7.5 percent U.S. equity returns most recently in their Monte Carlo simulations (reported return assumptions ranged from 3 percent to 10 percent). “I am no longer complacent about long-run average equity returns. Returns are not preordained and can remain flat or negative for multi-year and even multi-decade periods,” one private investor said. Interestingly, investors appear to be more likely to re-evaluate their assumptions about traditional asset classes than their assumptions about alternative asset classes.

Family Dynamics
In addition to changing the assumptions that are going into their portfolio models, 43% of investors said their families are also changing the way they make investment decisions as a whole.  For example, some may be rethinking the way they structure their portfolio, with well over a third saying they now use risk budgeting, goals-based planning, a wealth allocation framework,⁴ or a similar exercise in their investing. If this finding is indeed a shift (we do not have the data to compare), it may suggest that investors are looking beyond a pure “optimal” portfolio.

Family members’ views on how the family’s wealth should be managed may also be undergoing subtle shifts. For example, a quarter of respondents say that senior family members are exerting more control over asset allocation, and 22 percent have noticed more dissension among family members when discussing the family’s investments, perhaps owing to stress from the past year’s performance.

Lessons Learned as Told by Investors
Investors have certainly changed as a result of these strenuous market conditions. One way to understand this change is to look behind the statistics and see what investors are saying anecdotally. The following are some of their anonymous quotes:

• “In regard to investments, losing money bothers me more than missing a great opportunity for gain.”
• “I am way more interested in preserving wealth than I thought I was.”
• “I am more sensitive to the long-term cost of leverage and the downside risks here. Previously, I looked at leverage simplistically and thought as long as the return on debt capital was higher than the cost of capital, leverage was a good thing. My family [members] are all de-levering their personal and, in some cases, business balance sheets, to a level of leverage which is sustainable during extreme times.”
• “Pay more attention to liquidity!”
• “One must be willing to question investment assumptions and the modus operandi while being open to new ideas.”
• “Having a solid long-term plan that performed about as planned is comforting for the long haul. However, it is not fun being down in the short run.”
• “Don’t blindly follow what advisers recommend…. Formulate your own opinion and make corresponding decisions.”
• “My long-held belief that one shouldn’t try to time the market has been shaken.”
• “My caution has been merited.”
• “Trust the stop-losses.”
• “Our gut told us to sell earlier — and more severely — than our professional advisers advised. We should have overridden them earlier than we did.”

One investor summed it up perfectly: “All investors desire high returns while taking low risk. This logic (illogic) is hard-wired into all human beings and is incongruent with the way financial markets actually work. Investors seem to understand the risk/return paradigm intellectually but refuse to accept it emotionally.”

Christina Yeh is associate director of content at the Institute for Private Investors. 

1. This situation is described as “time inconsistency” or “dynamic inconsistency.”

2. IPI survey, “Fight-or-Flight (or Freeze)” (Spring 2009).

3. IPI survey, “Three Years into a Bear Market: Family Performance Tracking” (Spring 2003).

4. Ashvin B. Chhabra, “Beyond Markowitz: A Comprehensive Wealth Allocation Framework for Individual Investors,” Journal of Wealth Management (Spring 2005).