When smart people do dumb things with money

Investors can a learn a lot from pension funds, particularly when it comes to diversification, risk management and long-term thinking. But it seems professional money managers are not immune from the behavioural challenges that plague retail investors.

Doug Cronk, who writes a useful blog called Institutional Investing for Individual Investors, recently pointed me to a couple of industry articles that make it clear the pros are just as human as the rest of us. (I interviewed Doug last fall for an article called “Invest like a pension fund manager” in Canadian Business.)

In a February article in Pensions & Investments, a strategist explains that many pension funds have an investment plan that calls for them to increase their allocation to bonds when their plan is well funded. This is what investors might call “taking risk off the table”: the idea is that if equity markets have been strong and you believe you’re comfortably on track to meet your goals, you can afford to reduce the risk in your portfolio. However, the strategist says many fund managers are reluctant to carry out this plan: “According to their glide path they should be starting to shift asset allocation now,” he says. “But they have this view of the market that equities are going to outperform bonds. They don’t want to do it yet.”

In other words, the fund managers are ignoring their own investment policies and taking on more risk than they need to because they’re caught up in this long bull market for stocks. They’re reluctant to invest more in bonds, even though the role of fixed income is to manage risk, not deliver higher returns than equities. Sound familiar?

Doing the right thing feels wrong

Another item from Aegon Global Pensions suggests this isn’t the first time investment committees have made this error. The right time to reduce risk in a portfolio is after equity markets have performed well, but that is also the time when it no one wants to consider it. And of course, the worst time to move to safer investments is after equities have already plummeted, but that’s when we’re most likely to do so—and that’s true for pension funds as well as Joe and Jane.

“When derisking was affordable, it was not perceived as being desirable,” the article says. “In 2008 however, derisking was seen as being desirable but was also perceived (rightly or wrongly) as being unaffordable.” In 2014, after several years of strong equity returns have put many pension funds in a stronger position, “derisking” has become affordable again. “However, it is very hard to persuade both members and sponsors to derisk at such a time, as equity markets are rising, interest rates are low and hedging seems both expensive and unnecessary.”

This is yet another reminder that successful investing is not about having superior knowledge, or access to the best research. Chances are every pension fund manager have those things in spades. It’s not even about having a thoughtful plan, because the pros have that, too. The real key to success is having the discipline to stick to that plan when your instincts are telling you to change course.