Some of your clients are just begging to pay higher taxes
The buy and sell decisions made by South African investors in response to market upheaval confirms what behavioural finance experts have known for some time: that the market extracts a steep behaviour tax from those who insist on switching in and out of funds in their portfolios. The latest Momentum Investments Sci-fi report suggests that your clients ‘lost’ R90 million in behaviour taxes in a single 12-month period. This ‘loss’ was further assessed based on four investor archetypes that the asset manager tracks.
The great switching frenzy
“The year starting October 2020 was a record period in terms of engagement between people and their portfolios, with 27994 switches and an 80% increase in the number of active investors,” said Paul Nixon, Head of Behavioural Finance at Momentum Investments. He added that investors in the study incurred a staggering R90 million rand switching-related behaviour tax during the period, representing a 3.5% reduction in value across investors’ portfolios. This behaviour tax is measured as the return sacrificed due to a switching decision.
An interesting observation, and one that asset managers and financial advisers should be able to use to influence positive behavioural change among their respective clients, is that the taxes ‘paid’ differed significantly across investor groupings. The report reflected on the return outcomes of four investor archetypes which Momentum Investments describes as assertive investors, anxious investors, avoiders and market timers. In the following paragraphs we describe each investor archetype in greater detail, before unpacking their response to market volatility and illustrating the extent of behaviour tax that their respective traits incur.
“The market timer archetype is made up of investors who are very active in de-risking or up-risking their portfolios,” said Nixon. Market timers do their level best to take action at market inflection points… In other words, they are hell bent on selling when they believe markets to be expensive and eager to buy back in when they think prices are low. This strategy has been pooh-poohed by most investment experts who stay slavishly loyal to the trusted market adage: it is time in the markets, not timing, that deliver returns. Per the Sci-fi report, market timers switched on average 3.14 times in the year under review, destroying just over R22 million rand in value, which equated to the highest behaviour tax in the study at around 5%.
The trend is your friend, sometimes
Assertive investors “love making investments based on themes or trends, and are very active in up-risking their portfolio and switching to things with really great past performance,” said Nixon. The problem with this archetype is that they are always switching to the top performing funds in the latest reporting period. We draw your attention to another favourite market anecdote here, being that past performance is not an indicator of future performance. Sound familiar? Yes, of course it does, because this comment is included as a disclaimer alongside practically every fund fact sheet or presentation you will read or attend these days. Investor that fit the assertive archetype switched 1.37 times, on average, and paid a behaviour tax of around 4.09% or R40 million.
According to Nixon, anxious investors do the oppositive of what assertive investors do. “Anxious investors tend to panic when market shocks occur,” he said. “They tend to de-risk their portfolios almost immediately, but it takes some time before they gain enough confidence to get back into the markets”. This phenomenon plays out time and again as investors sell out during the first part of a market correction, and then sit on the side lines in a safe, low risk and low return fund while the equity markets recover. Anxious investor cost themselves just under R10 million by initiating around 1.22 switches each, wiping 3.02% from their portfolios.
The final investor archetype, referred to as ‘the avoider’ is the most conservative of the lot. “The avoider tends to get stuck in safe, cash-based assets that tend to underperform inflation over the long term,” said Nixon. And this means that their conservative proclivity sends them head-on into the biggest investment return tax of them all, inflation. “Avoiders incur an inflation-related behaviour tax simply because their money is not growing in line with inflation; cash does not generate a return in line with inflation,” he said. Avoiders initiated around 1.21 switches, on average, incurring a behaviour tax of 1.11%. It does not sound like much, but that is still R11000 of each R1 million invested up-in-smoke!
The value of advice and advisers
Momentum’s analysis, going back to 2006, reveals that investors’ switching activities are destroying more value than they are adding back. Nixon pointed out that your clients almost always destroy value when moving their money around, and that they are more inclined to make switching decisions during periods of market volatility. There is evidence of high behaviour taxes around the 2009 Global Financial Crisis, the 2014 equity market pullback and, of course, around the pandemic crisis in early 2020. “Nobody can predict when markets are going to turn, so if you are switching money around and the markets happen to turn [then you find] that the behaviour tax accelerates quite quickly,” he said.
One of the concerning features of the 2020/21 pandemic period is that there has been a huge influx of money to the personal investment and savings industry without a similar demand for financial advice. Anecdotally, it would appear that individuals are responding to growing financial uncertainty by retaining control of their financial decisions. This is a counterintuitive trend given the Russell Investments’ 2021 Value of an Adviser report finding that behavioural coaching is a big part of the total value introduced by the financial advice process. They estimate that 2.02% of the advice-based value comes from this aspect. “People do not value behavioural coaching, at least not yet,” lamented Nixon. Asset managers and financial advisers will have to address this shortcoming to ensure that clients are aware of the role that financial advice plays in keeping them on the proverbial ‘straight and narrow’.
Important lessons
“The big lesson from this exercise is that anxious investors always destroy the most value over the long term,” said Nixon. “They are quick to move into safe assets when markets fall, but do not appreciate how quickly markets recover; they always struggle to get back into markets”. For example, following the March / April 2020 pandemic shocks, global equity markets had rebounded within three months. As a result, many investors got their buy and sell timing totally wrong. Market timers tend to do poorly when markets change direction frequently too, because they are most exposed to the consequences of frequent switching.
A deeper understanding of your client’s financial behaviour will assist financial product providers in developing and implementing hyper-personalised nudging strategies to improve future outcomes. “There are two big focuses at the moment,” concluded Nixon. “The first is to start looking at personality or psychometric traits of investors to try to figure out why they make the switching decisions that they do, and the second is to look at hyper-personalised nudging strategies”. Your future as a financial adviser could include how to get your avoider clients back into the markets in a timely fashion; how to get those market timers to sit on their hands for a moment or two longer; and how to achieve responsible gearing for assertive investors.
Writer’s thoughts:
It seems that financial advisers may soon be running a few psychometric tests on their clients in addition to the good old risk profiling task. Is this something that you might consider in your practice? And if not, do you at least agree that your clients loosely fit into the four investor archetypes referred to in this newsletter? Please comment online, interact with us on Twitter at at @fanews_online or email me your thoughts.
Comments
Fully agree,thank you Report Abuse
Their philosophy is what goes up must come down and in the meantime be patient and ignore the froth.
Probably more of us than you think. Report Abuse