“For indeed, the investor’s chief problem–and even his worst enemy–is likely to be himself.”
― Benjamin Graham, The Intelligent Investor
The Role of Portfolio Construction
First, what is portfolio construction? Two primary pillars of portfolio construction are setting an asset allocation for a portfolio and then selecting investments within each asset class. The asset allocation of a portfolio is the mix of different broad types of assets such as stocks, bonds, and cash or cash equivalents. Investment selection is the process of selecting specific stocks, bonds, and other investments.
Setting an asset allocation for a portfolio serves several functions including managing market risk and establishing potential portfolio volatility and return profiles. Each asset class has different risk and return characteristics, and each may behave differently in a particular market environment. Stocks have historically had higher long-term returns than bonds, but that has come at the cost of greater volatility. By diversifying a portfolio across both stocks and bonds, an investor may aim to capture the long-term returns of stocks, the income-generation of bonds, or a blend of the historical volatility of the two asset classes.
Asset allocation and its effect on portfolio performance has been studied at length. In 1986 Brinson et al, found that about 90% of the variation of returns of pension plans over a 10-year period were explained by asset allocation policy. In 2009, in The Importance of Asset Allocation Roger Ibbotson found that nearly 100% of the level of return of a portfolio is explained by asset allocation while anywhere from 40% to 50% of the difference of performance between funds can be explained by asset allocation policy. The other 50% to 60% of this difference was explained by timing, selection, and fees. In other words, asset allocation is an important factor in portfolio performance, but it isn’t the only factor.
Investment selection is one of those other factors. Again, this is the selection of which specific stocks, bonds, or other investments make up the portfolio. In The Importance of Asset Allocation, Ibbotson identified three primary components which explain the total return of a fund. The first was the return from the overall market movement which accounted for about ¾ of variation of returns over time. The remaining ¼ of returns was attributed roughly evenly to the other two components. The second component was the incremental return from the asset allocation policy of the specific fund. The final component was active management, or the return (alpha) from timing, selection, and fees. A follow-up study by Xiong et al. in 2010 found that, “With market movements removed, asset allocation and active management are equally important in determining portfolio return differences within a peer group.” The bar chart below from this article shows how the 1986 Brinson et al. study (BHB) and the 2009 Ibbotson study (HEI & IK) explained the different components of total portfolio returns.
All this research and scholarly work can be a bit much to digest, but here are a few of my key takeaways from all this reading.
- Being in the market is an important driver of returns.
- Portfolio construction cannot control or override the general direction of markets.
- Asset allocation affects the potential level of returns for portfolios.
- Security selection, timing, and fees all affect returns as well.
In 2008 or 2022, asset allocation and security selection may have influenced relative returns between portfolios, but the broad market moving in a negative direction was a major driver of returns for most portfolios in those years. What we have examined so far are investment returns. What we have examined so far are investment returns. However, investment returns are not necessarily investor returns, and the difference between the two is known as the “behavior gap”. A carefully constructed portfolio may set the potential for returns, but investor behavior plays a role in how much of that potential is captured.
The Role of Investor Behavior
According to DALBAR’s Quantitative Analysis of Investor Behavior (QAIB), the average equity fund investor enjoyed annualized portfolio returns of 9.8% over the decade ending 12/31/2024. By comparison, the S&P 500 index had an annualized return of 13% over that same period (Forbes). So, what caused this 3.2% performance gap? The QAIB report suggests that it’s primarily investor behavior. Poor timing may contribute, such as investors buying after strong performance (buying high) or selling when markets decline rapidly (selling low). Additionally, when investors switch investments or investment strategies frequently, they have more opportunities to buy or sell at inopportune times.
Investor Returns vs. Investment Returns
I have had many conversations with investors who want to know how to avoid the worst days of losses in the stock market. It’s a great question, but I have not yet found a satisfactory answer. If an investor could know exactly when to sell to avoid losses and when to buy before huge gains, they would be incredibly successful. Unfortunately, it is difficult to know when large market moves will occur. Additionally, market volatility tends to be clustered with large gains and losses occurring close together. A recent example of this occurred in 2025 when the S&P 500 index fell more than 12% over 4 trading days from April 2 to April 8. On April 9, the index gained 9.5%.
The Effect of Missing the Best Market Days Over the Last 25 Years
One common way market timing is discussed is by examining how missing the best days in the market would impact long-term portfolio returns. The short story is that a few days of big gains contribute substantially to long-term returns.
The Effect of Avoiding the Worst Days in the Market
Another way to look at this is, what if an investor could avoid only the worst days in the market? The chart below shows substantial outperformance of the portfolio that timed this perfectly.
The problem with the market timing modeled in these charts is that accurately predicting short-term price movements is challenging, and doing it consistently is even more difficult. Could an investor have correctly predicted the drop in April 2025 and sold on April 2? Would that same investor have known, or had the fortitude to buy back their positions on April 9?
I once spoke with an investor who told me how his son, who worked in real estate, had expressed his skepticism about the markets in 2007. This investor sold nearly his entire portfolio to cash in late 2007 and avoided the massive drawdowns of 2008. That was incredible timing, whether by luck or skill. The problem, however, is that I spoke to this investor in 2019 and he was still mostly holding cash. For the 12 years leading up to our conversation he had yet to return to the markets out of fear of timing it wrong. As a result, he missed out on at least part of the longest bull run in U.S. stock market history.
In the field of behavioral finance, scholars aim to explain the behaviors identified in the QAIB report above. One way of explaining these behaviors is by defining cognitive biases which lead to these behaviors.
- Loss aversion bias explains how people tend to prefer avoiding losses over acquiring equivalent gains. In other words, losses feel worse than gains feel good. This can lead an investor to hold onto an investment that has lost value in the hopes that it will recover, or to sell winners prematurely to avoid losing the gain.
- Experiential (or recency) bias occurs when an investor’s memory of recent events leads them to believe that a similar event is more likely to occur again. This may have been at play with the investor above who avoided a major stock market decline and was worried another one was just around the corner.
- Action bias explains how people tend to prefer action over inaction, even if inaction would lead to a better outcome. Doing something can feel better than doing nothing.
There are many cognitive biases which may lead to investor underperformance (Investopedia). Being subject to any such cognitive bias is not a failing of any one individual. We all fall victim to cognitive biases. However, developing skills and strategies may help investors manage the risk of making these mistakes.
Building Behavioral Discipline
So what strategies, policies, or skills do investors employ to preempt cognitive biases? There are many options including pre-commitment tools such as developing an investment policy before investing, systematic strategies like automation, or mental practices such as framing and goal setting.
Starting with pre-commitment tools, investors can craft an Investment Policy Statement (IPS) prior to investing. An IPS is simply a document which outlines investment goals, asset allocation, investment strategies, and more (AAII). The IPS may also set procedures for reviewing portfolio performance, guidelines for trading in the portfolio – such as rebalancing rules, and triggers which would warrant amending the investment policy.
Creating an IPS requires investors to both reflect on who they are as an investor and think ahead to what they want to accomplish. For instance, setting an asset allocation or investment strategy may involve thinking about risk tolerance, risk capacity, and time horizon for the investments. An individual investor may decide that they want to review and amend their IPS during major life events such as marriage, the birth of a child, or retirement.
An IPS can be used as a reference document. An investor can check it when considering changes and ask questions. Do events meet the criteria I outlined for trading? Does my portfolio still accurately reflect my intended strategies? Have my circumstances changed in a way that would warrant a change to my investment policy? This up-front work may help an investor slow down during stressful market events. As the saying goes, “under pressure, you don’t rise to the occasion; you default to your level of preparation.”
In addition to drafting an IPS, investors may also choose to use automation for things like contributions, distributions, or rebalancing. Automatic contributions ensure that an investor continues investing on a periodic basis regardless of what is happening in the markets. Automatic contributions are a simple way to achieve dollar-cost averaging which is investing a constant dollar amount in a given investment in regular intervals. Dollar-cost averaging is a way for an investor to hedge against buying an investment in a single lumpsum at a high price. Automatic rebalancing is a way for investors to periodically realign their investment portfolio with the intended allocation outlined in their IPS. Automatic contributions don’t guarantee a lower average price, and rebalancing doesn’t ensure outperformance. However, these methods of automation allow an investor to stick to a strategy and remove the anxiety of choosing the perfect timing for these actions.
Finally, investors may find it helpful to frame their investments around their goals or long-term outlooks. Instead of focusing on what the market is doing this week, remembering why you are investing (retirement, college, a legacy) and what progress you are making on that path can be a useful technique to block out the noise of the moment.
A financial advisor may be able to help investors with much of what has been discussed in this article. Yes, an advisor will often help clients with portfolio construction, but the job usually doesn’t end there. Many financial advisors help clients develop their investment policies by asking questions to get their clients thinking about their goals, risk tolerance, or even emotional investment triggers. Vanguard’s Advisor Alpha study suggested that financial advisors may add up to 3% net returns for clients through a variety of services including portfolio construction, tax-efficient strategies, and behavioral coaching (FatFIRE). Notably, half of that 3% net return was attributed to behavioral coaching. Now, this is just one study, and it is from an asset management firm, so it’s important to consider the limitations of such a study. However, the point made in the study is that advisors may help their clients by providing perspective during market volatility, supporting disciplined saving and investing habits, and acting as a buffer against emotional decision-making which might otherwise lead to poor investment outcomes.
What is the most important factor that drives investor performance?
There isn’t really one simple trick. As academics like Brinson, Ibbotson, and Xiong found in a variety of studies, portfolio construction and management decisions all have a measurable impact on portfolio returns. The general direction of the market drives returns broadly, but asset allocation, investment selection, timing, and fees all play a role in setting the potential of a portfolio. Investor behavior also plays a substantial role in the capture of returns as evidenced by ongoing research such as DALBAR’s QAIB report.
Investors can control some of these things to varying degrees. None of us have control over the general direction of the market, which is a major driver of returns. However, we can develop thoughtful investment policies, monitor them, and update them as things change. We can automate some parts of our investment strategy to make sticking with our plan less work. We can be aware of cognitive biases and do our best to develop strategies to reduce the risk of falling victim to them.
If you find yourself with questions about any of this information, please reach out. We would love to have a conversation.
Disclosures: This material is provided for informational and educational purposes only and does not constitute investment, legal, tax, or accounting advice. Nothing herein should be construed as a recommendation, offer, or solicitation to buy or sell any security, to adopt any investment strategy, or to engage Howe & Rusling, Inc. (“Howe & Rusling”) for investment advisory services. Any opinions expressed are as of the date of publication and are subject to change without notice. Investing involves risk, including the potential loss of principal. Diversification and asset allocation do not ensure a profit or protect against loss in declining markets. Past performance is not indicative of future results and no investment strategy can guarantee success. Any examples, charts, or illustrations are provided for discussion purposes only. They may be based on assumptions and/or historical index data and do not reflect the performance of any client account. Actual results will vary and may be better or worse than those shown. References to market indexes (e.g., the S&P 500) are for comparison and educational purposes only. Indexes are unmanaged and cannot be invested in directly. Index performance does not reflect the deduction of advisory fees, transaction costs, or other expenses that would reduce returns. Information from third-party sources is believed to be reliable, but Howe & Rusling does not guarantee its accuracy, completeness, or timeliness. Statements about market conditions, returns, or outcomes may be forward-looking and are inherently uncertain; actual results may differ materially due to a variety of factors, including changes in economic and market conditions. Investment advisory services are offered through Howe & Rusling, an investment adviser registered with the U.S. Securities and Exchange Commission (“SEC”). Registration with the SEC does not imply a certain level of skill or training and does not constitute an endorsement by the SEC. Advisory fees, brokerage commissions, and other expenses will reduce returns. Howe & Rusling’s advisory fees, services, and potential conflicts of interest are described in its Form ADV Part 2A (Firm Brochure) and other disclosure documents. Howe & Rusling’s Form ADV (including Part 2A and Part 2B) is available upon request and at the SEC’s Investment Adviser Public Disclosure website (adviserinfo.sec.gov).
