Human behavioural biases account for more investment phenomena than most professionals would like to admit.
Those who believe that markets are efficient, or that collectively we act rationally, struggle to reconcile with panic crashes in markets or the fact that ‘momentum’ strategies have been proven to work over long periods of time. It’s difficult to claim that only fundamentals matter, when you see a popular growth stock rally on the back of a tweet or because ‘it’s already going up’.
For an astute investment manager or financial advisor, you not only have to admit to the influence of behavioural biases, but its integral to the service you offer to clients that you also account for such biases. Most psychological biases are survival instincts, good for recognising short term threats, but ironically becoming the threat themselves over longer timeframes (particularly when it comes to a long-term advice strategy, as well as investing itself).
Returns may be important, but investor behaviour matters much more. This is one of the most important aspects of risk management for financial advisers
Why Does Behaviour Matter?
We all have biases that are part of human nature. A few recognisable ones include:
• We focus too much on what happened yesterday relative to what happened last decade – recency bias
• We allocate significance to the price we bought an asset at, irrespective of if there is a fundamental reason for that price – anchoring bias
• We feel far more pain in losing a dollar, than we feel joy in gaining a dollar – loss aversion
Individually these behaviours are dangerous, together they become disastrous for investment outcomes – but through managing for behaviour, an Adviser can deliver far better investment outcomes over the long term.
Most advisers loathe the behaviour of performance chasing, where a client seeks the recent highest return with little regard to risk – this is what leads to clients abandoning an investment strategy that has phenomenal 10-year returns, because they’ve gone through a 3-year period of underperformance.
But rather than consider the umbrella term of performance chasing, those three biases we just mentioned can be identified as the culprits:
• The client focuses only on the past 1-2 years of performance from a manager or asset – recency bias
• They compare this performance to some other investment they might have held or followed, irrespective of if it’s an appropriate comparison – anchoring bias
• They will panic out of an asset which might be underperforming (regardless of it’s a hedge and meant to be doing that), and pile into assets which have been going up recently – loss aversion
We imagine many financial advisers and investment managers would get more hours of sleep throughout their career if they were not contending with a value-destructive behaviour like performance chasing, all borne from these identifiable biases.
How Do You Manage Behaviour?
In a perfect world, you would only have to consider total investment returns for clients.
In reality, we don’t know when clients might need to withdraw funds, or what their maximum volatility might be – a client might tell you they can ride out the bumps, but what is their real number? 5% drawdown, 10%?
If an adviser tries to manage purely to total investment returns with zero consideration for risk or how bumpy the ride is to get there, then they may find themselves without many clients who stick along for the whole ride. Meanwhile, those clients who sold out due to a drawdown are unlikely to know when to buy back into the market and will be left with a far poorer result at the end of that 10-year period.
Depending on the client and their level of loss aversion, often a robust, risk-aware approach can lead to better outcomes over the long term. . If you can keep the ride smooth along a long period, you’ll not only generate superior returns, but also keep the client invested with you for the journey.
An Example – Mr Clive Client
Let’s imagine a financial adviser takes on a new client, Mr Clive Client. Clive is in his mid 20’s, with a high-risk profile and a high-paying job. Clive, like many young clients, takes an interest in markets, and insists upon a high-growth strategy for his portfolio.
In the perfect world scenario, Clive’s advisor could get away with putting the portfolio entirely into risky assets (in this example, Aussie equities), with no consideration for risk – and Clive would tolerate any volatility, knowing that in the long run his performance would be superior to a portfolio which seeks to smooth out the journey.
The Risk-Naïve portfolio did meaningfully outperform, but in doing so saw annual volatility of over 13% versus the Risk-Managed portfolio realising just over 7%.
In reality, that difference in volatility could prompt some destructive behavioural responses from Clive.
Let’s say that during two major sell-offs in this period (the GFC and COVID), Clive panicked and told his advisor to sell out of his Risk-Naive portfolio entirely – and only decided to get back in when it was clear the market was performing again (the start of 2013 and Q4 2020 respectively). This is not uncommon, it’s all too common that retail investors sell at the bottom of the market and do not find the confidence to re-enter until it’s clear that prices are already recovering.
Here, Clive’s loss aversion kicks in and he exits the market during some of the best opportunities to purchase assets at discount prices. Instead, he chases performance only once things are looking positive again.
However, in the Risk-Managed portfolio, he feels more comfortable with the volatility, and the result is a far superior outcome and one where if he did have to withdraw funds for an emergency along the way, his adviser would have been able to produce a far better financial outcome for most of this 27 year time period.
Work with behaviour rather than against it
Destructive behavioural biases are part of human nature, we cannot ignore them any more than we can try to force ourselves, clients or the market to act rationally in spite of them.
To deliver a superior outcome to clients, we need to manage capital in a way which accounts for these behaviours, being aware of risk and volatility and smoothing the return profile in a way that allows clients to stay invested and fully participate in the benefits of compounding.
In a perfect world, you might just shoot for the highest performance number, allocate to whichever asset has the highest growth rate – but if clients need funds in the intervening volatile period, or worse yet succumb to destructive behaviour and forced sell, then the outcome will be meaningfully worse in the long run.
For more information about behavioural biases and strategies for managing client behaviour, download Innova’s latest white paper, portfolio construction: avoiding bad behaviour.
