Portfolios are more likely to fail because investors do not think like computers and are often too emotional about their investments.
Emotion in investment is also one of the main sources of poor advice from professionals, claims Greg B Davies, who is head of behavioural and quantitative investment philosophy at Barclays Bank.
Davies argues that investing is not just about economic theory, but knowing what to invest in and when and controlling emotional responses.
“Stress makes investors take decisions that put them in their comfort zone,” said Davies.
He explained these decisions typically involve:
- Concentrating on the short-term
- Over reaction to market movements
- Investing in local or familiar assets, while ignoring those an investor knows less about even if the risk is similar or less
- Buying high and selling low
- Stashing to much capital away as unproductive cash
“Behaving in these ways drags down long-term returns,” said Davies. “Making investment decisions for emotional comfort may make an investor feel better, but making short-term decisions usually leads to a poorer long-term performance.”
As an example, Davies explained many investors sold in the trough of the market at the end of 2008, start of 2009. Selling relieved stress because investors knew they would not lose any more money.
“The problem is this locks in losses and makes getting back in the market more difficult regardless of the emotional logic,” he said.
So what should investors do when faced with the anxiety of losing money in a falling market?
Nothing, says Davies. Control emotion and do not react unnecessarily.
“If you are stressed by your investments, simply opt for a portfolio with less risk,” said Davies. “Doing so will probably reduce long term yields, so is an expensive option, but it will make you feel more comfortable.”
That’s why wealth managers like Barclays employ behavioural experts to help investors assess their attitude to risk.
Financial firms have to profile their clients as part of the ‘know your customer’ requirement from regulators to make sure they do wrongly sell products and services.
However, many clients are unaware that the same profilers ‘design’ financial products to appeal to their risk traits.
Investors need to understand that risk assessment is a two-way street.
Even the Financial Conduct Authority is publishing a series of papers on the topic.
“We want to better understand mistakes made buying financial services, how advisers respond and how the market should adapt,” said an FCS spokesman.
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