When it comes to investing, customers are not always as rational as they think they are and may often reduce their returns by poor investment behaviour. Market volatility may exacerbate these issues and arguably lead investors to suffer worse outcomes than perhaps they should achieve. Financial advisers (IFAs) have an important and valuable role in helping their customers avoid or mitigate these issues.
The Behaviour Gap
Economic theory often posits that individuals behave in a rational manner and the efficient markets hypothesis states that all existing information is included in the market price of assets. However, research provides evidence that rational behaviour is often lacking and human emotions influence investors in their decision-making process.
While it is debatable how best to measure the gap between the return which could be achieved and the return our poor behaviour delivers (the behaviour gap), there is less doubt about whether it exists and what causes it. Some estimates put the behaviour gap between just over 1% and just over 4% (though there is dispute at the efficacy of the latter’s methodology) – Betterment has a useful summary of these studies (below):
Estimates of the behaviour gap chart:
So how irrational are we?
Here is a quick summary of some behavioural theories and their impacts.
- Regret Theory
Regret theory, the emotion people experience after realising they have made an error in judgement. Affected by the buying price of the fund, they then may not sell it to avoid the regret of badly investing or the embarrassment of reporting a loss. And if an investor only considered buying a fund and it increased in value, then there may be the feeling of having missed out.
- Mental Accounting
Humans tend to compartmentalise events and the difference between these compartments sometimes impacts our behaviour more than the events themselves e.g. the hesitation to sell an investment that once had large gains and now only has a small gain.
- Prospect / Loss-Aversion Theory
Prospect theory suggests people express a different degree of emotion towards gains than towards losses. Individuals are more distressed by prospective losses than they are happy from the same size gain. They may also risk holding on to losing funds to avoid losses than to realise gains.
In the absence of better or new information, investors often assume that the market price is correct. People tend to believe recent market views, opinions and events, and mistakenly extrapolate recent trends that differ from historical, long-term averages and probabilities.
Investors take an optimistic approach with a rising market and a pessimistic one during downturns. A consequence of anchoring or placing too much importance on recent events, while ignoring longer-term data, is an over- or under- reaction to markets. So, we see prices falling too much on bad news and rising too much on good news.
People generally rate themselves as being above average in their abilities. They also overestimate the precision of their knowledge and their knowledge relative to others. Overconfidence results in excess trades, with trading costs eroding performance.
- Reaching for yield
Since the global financial crisis interest rates have been at low levels and there is growing evidence that these low interest rates increase investors’ appetite for risk taking, a phenomenon referred to as “reaching for yield.”
What can advisers do to help?
A key role of the IFA is to be aware of these issues and to help coach investors through them. And to employ strategies to assist, which may include:
- Setting long-term goals – perhaps use cashflow models to help and show clients what a 20% fall looks like in £s terms. Make it real for them so when it happens, they are ready.
- Keeping an eye on costs – Morningstar found that the best predictor of fund performance is fees, simply because paying too much directly erodes your performance and directly contributes to the behaviour gap.
- Trading infrequently (and cost effectively) – use pre-funding and free switching on platforms to rebalance.
- Diversifying – a carefully targeted portfolio enables customers to reap the benefits of an “optimised” portfolio designed to meet their long terms needs with an appropriate capacity for loss, without the need for regular expensive intervention.
- Being aware of client biases – a client who has experienced five years of 10% annual returns is likely to expect that going forward, when the reality may be less appealing than that.
- Reassuring – despite every effort at inoculating clients against bad behaviour, it is inevitable that some are going to panic in volatile times, which is where your just-in-time support and advice come in.
The way we are wired as humans has ensured our survival as a species over thousands of years, but it turns out to possibly be a considerable hindrance in our ability to run investment portfolios effectively. There is a clear and valuable role for IFAs to help and coach customers to close the “behaviour gap” and flourish.