In our previous blog, the Cost of Volatility, we conclude by saying that “Having a well-constructed portfolio means having a palatable portfolio that is naturally diversified, where the risk is just right, unforced errors are mitigated, and discipline requires little action.” Achieving a diversified portfolio is fairly easy, but removing unforced errors and establishing low-action discipline is a bit more difficult.

Robert Arnott and John West from IndexUniverse.com take a look at negative alpha, and in their article, they do a good job at uncovering what some of those unforced errors might be.

Negative alpha is defined as “the slippage investors unnecessarily incur in the execution of their investment strategies.” There are three main aspects of negative alpha, including equity concentration of a portfolio, failure to rebalance, and chasing winning funds with high returns. Ultimately, one’s risk tolerance needs to be properly assessed to deliver a palatable portfolio of equity and fixed income. Within that portfolio, we believe that equities should be globally diversified with a tilt to small-cap and value-style exposure. Once that’s achieved, rebalancing guidelines need to be established. As long as the rebalancing mandate is not too restrictive or too loose, then it becomes easy to avoid chasing top-performing asset classes as rebalancing will naturally sell high and buy low.

For more in-depth analysis, please visit “A Crisis Review of Negative Alpha” at IndexUniverse.com.

Self-preservation is universal across all organisms. In the face of danger or pain, it is just in the nature of life to stop the pain and avoid the danger. Some organisms are more effective than others, and thus some species have been able to evolve and flourish more readily. Humans take self-preservation to another level and apply the concept to more than just oneself. We apply it to our friends and family members, strangers, our pets, and of course, to our investments.

As fortune would have it, we naturally associate losses with danger and the instinct is to Sell, Sell, Sell! Then, when returns turn positive, we become euphoric and our gut tells us to Buy, Buy, Buy! The following chart shows equity mutual fund cash inflows (in blue) alongside bond fund cash inflows. An overwhelming number of investors sold at the bottom, missed the rebound, and bought back in at more expensive levels.

Timing the market may appear to be a primordial result of the desire to self-preserve. Successful investing requires resisting these urges that may be quite adaptive in other avenues of behavior.