Greg B. Davies of Barclays Wealth explains some of the emotions and behaviours driving investors’ decision making, and reveals how advisers can help clients address these for the benefit of their portfolios.

Date: Apr 2012

Tags: Behavioural finance, Loss, Risk

• It is important to remember that there is always uncertainty with investment – so it is about how investors respond in these situations
• When emotional time horizons shrink, investors start to focus much more on the short term and leads to a misalignment with their current decision-making process and actual financial objectives
• The industry should help people to maintain a reservoir of emotional liquidity as well as looking after their financial liquidity
• Advisers can help clients deal with times of stress through ongoing education, changing the structure of the portfolio, and helping investors understand who they are and their financial personalities

When analysing trends in investor behaviour in response to recent volatility and uncertainty, Greg B. Davies said in an interview that it is important to remember that there is always uncertainty.

Anyone who is going to invest to try to get good returns is taking investment risk, he explained, adding that there will always be periods where portfolios will be down.

However, what is important, said Davies, is how investors respond in these situations – which is where the psychological elements and understanding of personality matters.

For example, it is during times like the last quarter of 2011, when markets saw some big drops with some extreme volatility, that individuals’ emotional time horizons shrink and they start to focus much more on the short term and to achieving the objective of emotional comfort, he explained. This takes their focus away from achieving a long-term, rational risk/return trade-off, and in turn means there is a misalignment with their current decision-making process and actual financial objectives.

As a result, Davies said people start focusing on loss and begin to perceive risks to be much higher than they are when viewed through a long-term lens.

Market response to this behaviour

When such behaviour occurs, the market starts to price in not just risk in the traditional sense, but the anxiety of market participants, explained Davies.

The better environment early in 2012 is not necessarily a result of a re-pricing of risk, because many of the issues that existed at the end of last year are still there now. What has changed, however, is that people have become more comfortable and have stopped the intense focus on the short term, he said.

This has meant that the anxiety discount seen last year has largely disappeared, he added.

How to shift to a long-term focus

According to Davies, the financial services industry cannot say investing is simple, and that investors should just diversify and stick with it.

In fact, investing isn’t simple, he explained, because of human reactions and emotional responses to outcomes as they occur.

The industry needs to recognise this, said Davies, and that people have a reservoir of emotional liquidity as well as financial liquidity, and that if they run out of that emotional liquidity, it doesn’t matter how well they are invested for the long term, their emotional responses will kick in and take over.

So the industry should help people to maintain that reservoir of emotional liquidity as well as looking after their financial liquidity.

How client advisers can help investors

Davies said there are three main things that advisers can do to help clients deal with times of stress.

First, is education, and continuing to tell people what the right thing is, so that gradually they will get a bit closer to where they should be.

But in conjunction with this, and to ensure they can use the education and knowledge to stop their emotional brain taking over in terms of stress, the second thing advisers can do from a practical perspective is to change the structure of the portfolio, added Davies.

This means not aiming for a perfectly rational portfolio, as that might make a client feel uncomfortable and then they will fail to achieve it. Instead, he said, the focus should be on sacrificing some of the long-term optimality to purchase emotional insurance.

This involves seeking products which smooth out the short term, possibly at a cost, he added, because they might involve a derivatives overlay, a downside protection, or some active management or dynamic portfolio techniques. But paying this small amount will prevent a much a bigger and more expensive cost as a result of knee-jerk responses going forward.

Thirdly, Davies said advisers can, over time, help investors to improve their decision-making processes. This starts with helping them understand who they are and their financial personalities, and then helping them to develop a set of investment rules and guidelines to follow. From this, when they come across an investment, they are not making a blind decision from scratch.