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Morningstar 2008: Accentuate the cognitive

This morning Bill Bernstein, a former neurologist who has since become a financial guru and founded EfficientFrontier.com, gave a free-form talk about his investment approach.

Various rebalancing tactics were examined in order to take advantage of differences in return that exist among asset classes. “I believe threshold rebalancing is better than calendar rebalancing — but I can’t prove it,” he stated, noting that wide thresholds (1-2 years) were better than narrow (3-4 times per year), and that calendar rebalancing should occur no more frequently than once annually. This gives your winners (and losers) a chance to run and receive the benefit of their momentum before the rebalancing takes place.

Bernstein claimed not to be especially interested in behavioral finance, despite his having practiced as a neurologist for 25 years. He did assert that it was good for examining and exposing one’s own biases, however. Like piloting a plane, investing is an exercise in learning to master (and often contradict) your instincts.

Emotions generally pose a greater threat to individual investors than to financial professionals. Bernstein suggests that the greater threat to investment professionals is cognitive, versus emotional, mistakes. The two most important errors he cited were (1) not knowing enough investment history to give proper context to whatever upheavals are occurring in today’s markets, and (2) making the mistake of equating economic growth with equity returns. The example he gave for the latter was China, where massive economic growth over the last decade and a half was not matched by comparable equity returns over the identical period.

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