Asset Allocation and Bad Habits

Abstract

This article documents the “bad habits” of investors in asset allocation practices. Whereas financial markets exhibit momentum over multi-month horizons but more reversion to the mean over multi-year horizons, many investors act like momentum investors even at these longer horizons. Both these patterns are well known anecdotally but have not been well documented statistically, especially together. This article therefore addresses two empirical questions. First, How do funds reallocate based on past returns? The authors provide direct evidence using the CEM Benchmarking data on pension fund target allocations over a 22-year period. Second, What are momentum/reversal patterns in financial markets returns? Evidence is provided using more than a century of data. Merging the findings from the two data sets provides evidence consistent with the premise that investors chase returns over multi-year horizons, which is likely to hurt their long-run performance. However, the statistical evidence on pro-cyclical multi-year asset allocations and multi-year mean reversion patterns in asset-class returns is on the borderline of statistical significance.

Keywords: Asset Allocation, Mean Reversion, Momentum Investing, Pension Fund, Return Attribution