Chris Cuffe writes in a recent issue of his Cuffelinks investment newsletter that academics have named this overestimation of abilities and underestimation of weaknesses as "illusory superiority".
The over-ranking one's ability extends, of course, to many areas of our lives. For instance, Cuffe points to US surveys showing that more than 90 per cent of drivers rank their driving skills in the top 50 per cent.

As Cuffe says, one of the investment areas where investors display over-confidence in their abilities is in making short-term adjustments – commonly called tactical asset allocation (TAA) – to the long-term asset allocations of their portfolios.

"TAA is market-timing with a fancier name," he writes, "and usually involves switching from equities to defensive assets and vice versa in anticipation of a major stock market move. Unfortunately, nobody rings a bell to tell when this is about to happen..."

Cuffe has undertaken an interesting exercise which shows how different asset classes have performed in the past. (The tool enables investors to specify the asset allocation and the investment period.)

He looked at how a portfolio with a classic 70/30 asset allocation – 70 per cent in growth assets – would have performed in the 10 years from January 1, 2004 to December 31, 2013. His selected asset allocation was Australian shares (35 per cent), international shares – $A unhedged (25 per cent), Australian property – listed REITs (10 per cent), cash (5 per cent), Australian bonds (15 per cent) and international bonds (10 per cent).

Assuming no transaction costs or tax in order simplify the examples, $1,000 invested at the beginning of the period and invested in accordance with this 70/30 asset allocation would have grown to $1,962 in 10 years – a compound average growth of 6.98 per cent a year. This is on the assumption that the portfolio was not rebalanced each year.

However if the portfolio were rebalanced annually to return to its initial asset allocation, the $1,000 would have grown to $2,094 over the 10 years – a compound average annual return of 7.6 per cent.

Cuffe notes that large public super funds may allow a small range of adjustments either side of their percentage target allocation to each asset class (for their premixed portfolios such as balanced) but few would provide for major adjustments.

In his article, Cuffe also uses Vanguard's Asset Class Tool to illustrate the huge returns if an investor had managed somehow to foresee the market and had the tactical asset allocation perfectly positioned for each movement in the market over the past decade.

In reality, of course, attempts at trying to time the markets often end badly with potentially big losses for investors.

Cuffe concludes his article with a telling quote from Vanguard's founder Jack Bogle: "Sure, it would be great to get out of the market at the high and back in at the low. But in 55 years in the business, I not only have never met anybody that knew how to do it, I've never met anybody who met anybody that knew how to do it."

There is plenty for investors to think about here including: the benefits of setting and adhering to an appropriate long-term asset allocation, the perils of market-timing and the risks of having an inflated opinion about one's investment abilities.

By Robin Bowerman
Smart Investing
Principal & Head of Retail, Vanguard Investments Australia
02 October 2014