By John Wasik
CHICAGO Jan 25 During a market crisis, when
everyone wants to jump off the ship in the same leaky lifeboats,
that doesn't bode well for most individual investors, who simply
want to preserve capital.
The safeguard is to move against what behavioral finance
experts call the "bandwagon effect" -- when so many investors
follow the same path that they disrupt the traditional
correlation of assets.
This is what has happened when Modern Portfolio Theory (MPT)
-- a bedrock of investing that advocates diversifying your
portfolio to temper risk and boost returns -- met big
institutional investors who employed the idea on steroids,
plowing money into alternative investments from leveraged hedge
funds to timber.
In his new ebook "Skating Where the Puck Was: The
Correlation Game in a Flat World," William Bernstein, a money
manager and neurologist, credits the surge of going big with MPT
to David Swensen, the legendary manager of the Yale University
Endowment. His strategy of deploying more than half of the
college's portfolio in alternative assets such as timber, hedge
funds, private equity and commodities produced a 15.6 percent
annualized return between July 1987 and June 2007, besting the
benchmark S&P 500 by nearly 5 percentage points.
At the time, Swensen's success upended the ossified standard
practice of 60 percent stocks, 40 percent bond mixes. Seeing
that they could do better, money managers with significant
resources parroted Swensen's allocations. By the mid-2000s, more
than 800 large endowments and pension funds were mimicking
Yet emulation isn't the same as duplication. As everyone
jumped on the bandwagon of highly illiquid alternatives, returns
began to lag market benchmarks. By mid-2011, Bernstein found,
most endowments couldn't beat common gauges like the S&P 500.
Hedge funds, which also had a great run until the second decade
of the 21st Century, also started to become expensive laggards.
The bloom was off the rose.
The great alternative investment bandwagon effect surfaced
in a nasty way in 2008, when nearly every non-bond investment
followed stocks down in the most horrendous slide since the
Great Depression. Investors were shocked to discover that assets
they counted on as hedges to move in the opposite direction of
stocks instead went down the drain at the same time.
What happened then? Big investors panicked en masse and
dumped their riskiest assets simultaneously. Fear united the
horde. Government bonds, in contrast, stayed in positive
territory, because they were the only remaining safe havens. In
the interim, Swensen's Yale strategy suffered along with
everyone else holding alternatives: The university's portfolio
lost about a quarter of its value in 2008-2009.
HOW TO COUNTER
Bernstein, who has often taken a combined empirical and
common sense approach to managing money, argues that to
counteract such bandwagon effects, investors need to avoid
chasing the big boys on that latest alternative investment such
as hedge funds.
While diversification is never a bad idea, it is wise to
accept its limits and to gauge your total portfolio risk, which
is the sum of its parts.
One thing to consider is that when you see the stock market
collapse, it is too late. So Bernstein suggests in his book that
if you see that credit's becoming tight, you get rid of your
risky assets -- all of them -- and instead go for comfortably
government-secured vehicles. This may be difficult for most
people to track, so pre-determine the amount of risk you can
take and lower risk through diversifying into bonds,
money-market funds and federally insured vehicles.
It is also valuable to keep track of when the bandwagon is
getting wobbly. "I watch who's owning given asset classes,"
Bernstein said via email. "When everyone owns them, like
commodities and the SPDR Gold Trust (GLD) today, their future
correlations will most likely rise."
Where the rubber meets the road is translating potential
losses into terms you can understand in your real life, not just
numbers on a balance sheet. For instance, ask yourself if you
were to take a 20 percent loss, would you be able to retire
comfortably? Does a 40 percent loss keep you in the job force
for an extra five years, instead of allowing you to retire when
Still, you can continue to diversify as long as you
understand the risk/return nature of what you're investing in.
Assets can become un-correlated when markets function in
non-crisis modes. It's still possible to make money in emerging
markets when European stocks are flat or negative. Bonds still
offer protection against stock losses. Precious metals, real
estate and commodities may confer some upside during
The key to preserving and growing your wealth is to watch --
and avoid -- the bandwagon as much as possible and find the
portfolio medley that works best for you. Sometimes, as
Bernstein has well noted, there's no safety in crowds.