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Rewards in beliefs

Institutional investors, every day entering new territory in the financial markets, add to their risk by neglecting to develop a coherent set of beliefs about the capital markets and the economy to frame their investment process and guide its implementation.

Without such a foundation, investors risk reducing their returns by adopting asset allocations misaligned with their investment objectives, or producing whipsaw effects by making costly moves in reaction to market changes that turn out to be short term.

The results of a survey by Pensions & Investments and Oxford University point to the advantages of developing and embracing a consistent set of investment beliefs — assumptions about the economy, the financial system and risk that provide a foundation for investment decision-making.

An important conclusion of the survey is that embracing a set of investment beliefs can help investors overcome behavioral finance tendencies such as hindsight error, factors that cloud judgment.

But many investors, whether defined benefit fund executives or defined contribution plan participants, have yet to come to grips with formulating their core investment beliefs.

These beliefs and assumptions are not simply abstract ideas but have practical consequences for defined benefit plans, defined contribution plans and other institutions.

Defined benefit plan executives began to get exposure to investment beliefs years ago, in for example, the writings on security analysis by Benjamin Graham and David Dodd and in debates about market efficiency and active management vs. passive management. But many have not yet pulled their beliefs into an organized structure.

Much criticism of defined contribution plans (although they were not part of the survey) comes down to participants' apparent lack of clear investment beliefs. For example, many participants ignore the advantages of diversification by allocating large shares of their assets to company stock. Or they fail to understand market efficiency and its influence on active and passive management, performance and fees.

Pension fund executives and other institutional investors ought to develop a set of consistent investment beliefs to frame their investment process. Similarly, defined contribution plan sponsors should make such an idea part of their education programs, encouraging participants to develop their own set of logical investment beliefs as a framework for their investment decisions.

As the leaders of the survey note, developing such beliefs leads to greater introspection in the investment process, so that refining investment beliefs can lead to a more refined investment process.

Meir Statman, professor of finance at the Leavey School of Business, Santa Clara University, observed in his book, “What Investors Really Want”: “We are more rapidly informed than our predecessors a century ago, but we are neither better informed nor better behaved.”

Investment beliefs aren't infallible. The risk in embracing them is they can be wrong, or they might need revision as market and economic conditions change, or they can be misapplied, resulting in investment losses.

Even among investors who have a firm set of internally consistent investment beliefs there is no set of shared views on the markets and economy. That's what makes markets. The financial markets are places designed to facilitate transactions among hundreds of differing opinions, not just about a particular asset but also specific sets of assumptions about financial markets and the economy and other risks.

The survey found, for instance, wide disagreement about whether diversification across risk premiums generates greater returns than diversification across asset classes. Allocation by risk, so-called risk budgeting, has become more common in recent years. It represents an example of how investors are seeking to revise their beliefs to incorporate more sophisticated information about risk into their allocation process.

Among other findings, the survey found widespread differences on the value of integrating environmental, social and corporate governance criteria into investment decision-making.

The correlation of ESG to investment performance is still elusive. Investment managers are working on how to measure the effect ESG integration in investment decisions has on investment outcomes.

But investment beliefs, even when they prove correct in the long run, aren't enough to deliver superior risk-adjusted performance. Organizations have to develop the governance and expertise, internal and external, to frame beliefs into coherent investment policy, asset allocation and implementation in the selection of managers.

Events can still overtake the entire process, no matter how sound. But a system of core beliefs will keep investors from making snap changes and hold them to the time horizon they set, or create a rational way to revise their framework to adjust to new conditions. n

This article originally appeared in the August 6, 2012 print issue as, "Rewards in beliefs".