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Anxiety cost your clients R100 million in 2020

29 April 2021 Gareth Stokes

Ill-thought and ill-timed investment decisions taken to avoid the COVID-19 financial market correction have cost Momentum Investments’ clients more than R100 million between April and December 2020. A recent study by the asset manager concludes that behaviour-linked financial decisions caused the average investor to lose 6.5% of his or her portfolio value between March and September last year. It is now clearer than ever that investors destroy value by allowing their behavioural programming to undo sensible long-term investment strategies, selling out of equity positions that are meant to deliver returns over decades in response to market volatility that lasts, at most, a couple of quarters.

Investors were running for the hills…

“The COVID-19 financial crisis saw more than R1.5 billion in investors’ funds being switched between March and December 2020; when the financial markets crashed, investors ran for the hills,” said Paul Nixon, Head of Behavioural Finance at Momentum Investments, during an online panel debate on behavioural finance, held 20 April 2021. He added that switching activity in March 2020 was three times higher than the prior year, measured by number of switching instructions. Investors’ responses to the latest financial market collapse were similar to their responses to previous crashes; but they lost more of their portfolio values this time around due to the speed of the post-crash recovery. “Investors destroyed a lot more value because markets recovered so quickly,” said Nixon. 

The panel, which included behavioural finance experts and financial planners, set about determining what drives investors’ behaviour during a financial crisis. Nixon started the debate by referring back to five distinct investment behaviour patterns identified in a 2020 Momentum Investments’ study, namely assertive; anxious; avoiders; market timers and contrarians. Anxious investors, who exhibit a strong anxiety trait, have a low risk threshold and tend to ‘run’ for safety when markets wobble. “Investors in the anxious category lost the most through the crisis because they reacted quickly to falling markets. And by the time they got back into the market they had missed the recovery completely,” said Nixon. Momentum observed that investors in this category accounted for 41% of the R100 million value decimation witnessed last year. 

Avoiding short-term fluctuations by switching

Those in the avoiders category were responsible for the lion’s share of switching activity during the financial crisis; but ended up losing slightly less capital, around 16% of the R100 million, because they did not buy back into the markets at high levels. Both assertive investors and market timers lost money too, accounting for 20% and 23% of the combined value loss respectively. The best performers through the 2020 market mayhem were in the contrarian category, where investors typically protect their portfolio values by being greedy when the herd is fearful, and vice versa. 

Specialists in the field of behavioural finance are turning their attention to the link between investor types and financial advice in investment decision making. More specifically, they are keen to explore the impact that bias and noise in and around the financial advice process has on portfolios outcomes. “Much of what the behavioural science has focussed on over the last decade centres on human bias,” said Greg Davies, Head of Behavioural Science for Oxford Risk. “We appreciate that there is human bias in our financial advice and portfolio decision making; but noise is different”. A study was devised in which hundreds of participating financial advisers were given a holistic picture of one of six model clients. Advisers were asked to rate the model client’s risk appetite at between one and seven and then to structure a risk-appropriate portfolio based on that rating. 

“The advisers gave answers from low levels of risk to high levels for each of our model clients, proving that the current system is extremely noisy,” said Davies. And although the resulting client portfolios showed, on average, a smooth risk progression from low risk to high risk clients, the asset allocation in these portfolios was incredibly noisy too. “The recommended equity exposure [collated across the participating advisers] varied from around 10% to 90% for every one of the six client cases we presented,” he said. This is a sub-optimal result from a financial advice process that should give individual clients a consistent outcome across advisers and advice practices, untainted by financial adviser bias or system noise. 

Measuring bias and noise in financial advice

The financial industry has no idea how big the noise problem is. So, the study set out to ascertain how much of the observed variation was due to the information given to the adviser; how much was due to adviser biases; and how much was pure noise. An initial assessment showed that 70% of the divergence was due to unexplained noise; but further analysis suggested that 56% of this noise could be linked to various factors, leaving 44% as noise. 

For example: Around 20% of the variation is attributed to the adviser’s judgement of the client’s capacity to take risk. This variation is expected because advice should be influenced by the client’s risk profile. However, there is a serious disconnect between the information given about a particular client and the objective assessment that different advisers are making about this risk profile. “Advisers are coming up with some sort of objective assessment of risk and using that assessment to say here is a particular level of risk; but this seems to have no bearing on the information attaching to each client,” Davies said. 

An assessment of critical factors such as the investor’s willingness to accept risk or risk tolerance; financial ability or risk capacity; and emotional ability or behavioural capacity should deliver a consistent client risk rating from one adviser to the next. Unfortunately, the emotional or behavioural component is not adequately integrated into current advice processes as indicated by the divergent risk ratings and portfolio recommendations given in the study. “If humans are going to make good market decisions they need to get rid of emotional conflict,” concluded Davies. “This is why advisers are so valuable and powerful; [their ability to process emotion] is at the centre of the value they offer to clients”. 

Writer’s thoughts:
Experts in financial behaviour are suggesting that current risk modelling methodologies ignore your client’s emotional ability or behavioural capacity. They also argue that financial decision making should at least take account of your client’s behavioural traits. Does this view resonate with what you experience in your advice practice? And would you welcome revisions of existing risk profiling tools to include behavioural aspects? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts


Added by Gareth Stokes, 03 May 2021
Thanks for the comment Garrick... You make some great points. There are other factor that could explain the excessive choppiness in our unit trust environment.

One is the high percentage of retirees who opt for a living annuity structure at retirement. There are too many people caught between drawing enough income & growing their insufficient capital pot, with the result market swings cause additional stress / ill-thought switches.
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Added by Garrick Bergh, 29 Apr 2021
The problem with putting out somewhat simplistic ( albeit truthful) information like this is that it often misinforms more than it informs.
If you are referring only to bona fide investors then this article has merit.
But the reality is that a substantial percentage of so called 'investors' are actually older people who are drawing a regular income off their investments.
Do an exercise detailing the imapct of an income on a fund which suddenly halves in value (even temporarily) and you will note that the road to recovery is a lot slower than it will be for a dicretionary investor who can simply ride out the reversal.
Lastly - these articles are all written retrospectively. Like many market commentaries they are simply stale history lessons. It would be interesting to listen to the advice of these 'experts' whilst the crisis is unfolding and/or if we were still awaiting a recovery........

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