(13 AUGUST 2017)Thought of the week:5 mistakes that destroy your finances

Across markets, on average, only 7% of our non-under-contract clients outperform UBS Manage™ Advanced solutions. The figures are even lower for Ultra High Net Worth where, on average, only 5% of our non-under-contract clients have outperformed over the past 5 years.

1.There's no place like home when it comes to investing

The tendency known as "home bias" is one of the most common behavioral mistakes we observe in our clients. We disproportionately favor geographies and asset classes that we come across more frequently in our daily lives, a mistake that can cost in terms of missed return opportunities and increased risk.

Research from Vanguard determined that, over a period of ten years, US investors typically allocated up to 80% of their equity holdings exclusively to US equities. This phenomenon is even more pronounced in the fixed income universe, where US investors allocated over 90% of their portfolio to US instruments, over the same period. This tendency to over-concentrate in securities that seem familiar is not unique to US investors, and it is a pattern that we can actually observe in all the markets that we serve.

Modern portfolio theory explains how crucial diversification is to optimize portfolios: it allows to reduce the risk while keeping the same expected return.

2. Winners and losers have very different time horizons

Investment losses and profits are treated differently because clients fear losses more than they enjoy gains. This normally means that winning securities are sold too soon and losers are kept too long. In a client study, UBS WM Research determined that losing stocks tended to remain in portfolios for 124 days before being sold, while gaining stocks tended to be sold only after 104 days, on average.

Clients evaluate their investments with respect to a reference point, normally the purchasing price of the stocks they added to their portfolio. Even if research is independent, and the buy / sell / hold recommendations are made regardless of a specific entry point in the markets, our clients give different time horizons to losses and gains, irrationally. The common "wait until the loss gets back to even" bias also tends to be detrimental to overall portfolio performance.

3. Risk profiles drift through lack of maintenance

A carefully calibrated mix is the most important investment decision and this strategic asset allocation must not only be established, but must also be maintained for it to truly be "strategic" at all.

The fact of the matter is that re-balancing is tedious and requires constant monitoring. And at times it is emotionally uncomfortable to maintain consistent portfolio weights as markets shift. For example, as equity markets decline, re-balancing becomes appropriate but in times of decline buying equities to restore allocations weights is uncomfortable and often avoided.

4. We hyperactively change risk profiles

We have noticed that when the news starts to preoccupy investors, our clients tend to call and ask to shift their risk profile and respective investment strategies. However, these kind of hyperactive changes come at a cost; with a lower allocation to equities portfolios might be protected in bearish markets, but they also miss the markets' later rebound – an opportunity cost that our clients pay in terms of performance.

In essence: frequent shifts in risk profiles can destroy your finances.

5. Obsession with alpha

Many investors are tempted to choose star managers and "big" names in the financial industry blinded by their recent performance numbers, without really looking beneath the surface. This is only natural, but the pursuit of alpha should be placed in a proper context and with an awareness of how best to gain access to leading managers while also carefully managing various critical risks.

In essence, an unchecked obsession with alpha can destroy your finances, whereas exposure to world class managers within a selective portfolio approach can be a key factor in ensuring investment success. Diversification is key when investing into hedge funds.

(By UBS)