Three rules to stop the behaviour tax bleed
The best way to avoid paying too much behaviour tax and prevent the ongoing erosion of your (and your clients) investment account balances is to stay invested in through periods of market volatility. In fact, according to data contained in the Sci-Fi Report 2022, your clients now need to commit for around 14-years to ‘guarantee’ that their equity investments generate a real market return. PS, we use the word ‘guarantee’ with the disclaimer that there are few hard-and-fast guarantees in financial markets.
Stretching from eight- to 14-years
Time in the markets is the first rule to prevent cash ‘bleeding’ from investment portfolios, and the optimal period is growing. “The concept of ‘time in the market’ is changing … as is the landscape for investing into risky assets,” said Paul Nixon, Head: Behavioural Finance at Momentum Investments, during an exclusive interview with FAnews. Nixon’s is passionate about understanding behavioural finance, or the science of human financial behaviour, to improve long-term financial outcomes. His passion therefore centres on keeping people invested through the myriad curveballs that both domestic and global financial markets throw. To illustrate how important ‘time in the markets’ is, Nixon shared a trend analysis of JSE All Share annual returns that show the period of exposure needed to beat inflation has grown from eight-years a decade ago, to the 14-years mentioned in the opening paragraph.
The Sci-Fi Report uses transactional data from both the living annuity and unit trust environments to assess the impact of financial behaviours on your clients’ return outcomes, reporting the gains or losses caused by knee-jerk buy, sell or switching decisions as an annual behaviour tax. The 2022 report covers the period 1 October 2021 to 30 September 2022, a year during which many investors sought to evade volatility by shifting from high equity to cash or fixed income… For additional context, the report’s coverage ended with the JSE All Share index at 64 000 points, just missing the 15% move to 74 000 points that occurred between then and the end of November 2022. Unfortunately, this ‘spike’ will likely have caused many of your clients to suffer further behaviour tax ‘hurt’ in the ensuing period.
Investors jump ship whenever markets wobble
“If you look at the aggregate behaviour the data shows a tight correlation between market movements and switching behaviour,” Nixon said, adding that these switches were both uncoordinated and unrelated to investors’ goals. As the JSE surges, investors become annoyed by missing out on the resulting returns and begin looking for higher risk / return alternatives in their investment universe. Likewise, if the JSE falls, they seek to de-risk their portfolios by moving from higher risk to lower risk funds. The financial damage caused by these switching decisions varies with financial market conditions, investment type and your client’s behavioural archetype.
For example, the 2021 Sci-Fi Report, revealed that clients in the unit trust space paid (or lost) ZAR146 million in behaviour taxes compared to a ZAR490 million behaviour tax for clients in living annuities. Fortunately, the 2022 experience was far better. “The period under review turned out to be a big de-risking ‘play’ with clients moving from equities to cash and fixed income,” explained Nixon. This was an expected response given the levels of volatility in financial markets throughout the year. Alas, the de-risking moves could not fully accommodate the fickleness of markets, with this period being one of only a handful on record during which both equity and fixed income returns got “smashed”, though the latter asset class got smashed slightly less. “We ended up with a perfect storm; wherever you went in the markets you ended up getting nailed,” mused Nixon.
What archetype best describes your clients?
One of the key results from Momentum’s behavioural research was to categorise investors into four behaviour types (labelled anxious, assertive, avoider and market timer) and then determine the best approach to financial advice for each type. FAnews reported on these archetypes last year in a newsletter titled ‘Your clients are just begging to pay higher taxes”.
To summarise, anxious investors panic when markets fall, de-risking their portfolios almost immediately and taking too long to get back into riskier asset classes. Assertive investors, meanwhile, switch to higher risk funds based on themes or trends, and almost always choose the fund that tops the most recent one-year performance tables. This is an excellent time to introduce the second rule to prevent damage to your portfolio; namely, that past performance is not a measure of future performance. Avoiders are extremely cautious and tend to get stuck in safe, cash-based assets that underperform inflation over time, while market timers are active switchers that frequently risk and de-risk their portfolios. So, what does the latest Sci-Fi Report say about various archetypes’ responses to financial market volatility?
First, the avoiders, who make up one in every five investors, ended the year more-or-less flat. Their behaviour led to 1.42 switches on average but only contributed to a miniscule -0.07 behaviour tax. PS, a negative behaviour tax illustrates a slight benefit compared to the outcome from doing nothing. Anxious investors, who make up 38% of the report’s population, fared best of all, with a -3.44% behaviour tax form around 1.57 switches. “Assertive investors incurred a high behaviour tax of 4.5% for the year … people who steadfastly stuck to up-risking their portfolios were penalised heavily,” said Nixon. Finally, market timers, who make up 23% of the BREAK investor population, transacted far more often than any other archetype, making 3.19 switches over the year. This ‘investor ADHD’ delivered neutral results, as this grouping scored a moderate -0.86% ‘gain’ from their behaviour.
A fear-based affair
The period under review was a fear-based affair, illustrated by aggressive asset allocation shifts towards the cash side of the risk spectrum and lengthy delays in switching back into higher risk segments of the market. “People were moving from equity and balanced funds to cash and fixed income,” Nixon said, before warning that although this year’s behaviour tax ‘penalty’ was small compared to the prior year, it looks certain to return to trend for the 2023 Sci-Fi Report. The reason is that one cannot time the markets: investors always leave something on the table when exiting one fund and miss out on some gains when buying into another. Thus, we introduce the third rule to ‘stop the bleeding’, namely emotion-based switching almost always carries a return penalty. Your clients should only switch if the decision aligns with their financial plan.
The next evolution in financial advice could involve algorithms or machine learning that categorises your clients based on their financial behaviour archetypes. “The aim is to predict what your clients are going to do based on the 20-years of data that we have … each investor will be assigned a tag to illustrate the likelihood of them making a switch within the next month, for example,” said Nixon. “And when we get into that space, we can develop an intelligent ‘nudging’ system to alert both adviser and client to the likely impact of that switching decision”. Of course, the elephant in the room, acknowledged by Nixon, is the extent to which financial adviser archetypes are influencing client decisions.
Writer’s thoughts:
Time and again, the data proves that South African investors lose money when switching funds to avoid market volatility. There is also growing evidence that behavioural traits have a major influence on financial decision making, with often negative consequences. The question becomes: whose behavioural traits are most responsible for the country’s switching obsession; financial advisers or their clients? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.
