Removing the emotions from investment

advice covid emotions behavioural finance

14 February 2023
| By Industry |
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Given the volatility in domestic and international markets, Australian retail investors can be forgiven for becoming a bit emotional about their portfolios.

Record inflation and increases in interest rates to tackle rising prices in Australia are mirrored worldwide with the energy price crisis, the lingering impact of the COVID-19 pandemic, and the Russian invasion of Ukraine adding to uncertainty.

With markets in turmoil investors often take fright and look for emotional comfort by increasing their allocation to cash as they worry about market volatility. This is understandable, and reasonable. Naturally, people want to be able to sleep at night.

But emotional comfort comes at a price. At Oxford Risk we estimate the average investor foregoes around 3% a year in lost returns annually due to short term behaviours and emotional decisions in pursuit of that good nights’ sleep.

Over a lifetime the lost returns from money sitting on the side-lines mounts up; and investors make avoidable losses from timing mistakes such as buying high when times are good and selling low when times are bad.

Emotional support is vital

Wealth managers are ideally placed to help people cope with the emotional and psychological investing roller-coaster.

However, as many wealth managers we have surveyed admit, their suitability systems and processes for assessing client needs are not up to the task. Our research with advisers found nearly two out of three wealth managers (65%) agree that current systems are too reliant on subjective human judgement.

It is not that wealth managers are unaware of the issue of emotional investing – nearly three-quarters (73%) of them acknowledge emotional decision-making costs investors investment returns. The most common error wealth managers see is clients making impulsive decisions to the detriment of their long-term plans.

More than two out of five (41%) identified impulsive decision-making as one of the top three mistakes, followed by investors evaluating returns over too short a period (33%), and over-confidence (30%). Other emotional mistakes include investors comparing their returns with other investors, or too much reliance on familiar investments. 

But despite this awareness wealth managers often fail in the next step of supporting investors in their emotional journey. Many criticised their own existing suitability processes and systems for being too cumbersome – 64% said systems do not adapt quickly enough in responding to rapid changes in clients’ circumstances.

Tackling lost returns

Managing the investor is just as, if not more, important as managing investments themselves. A carefully composed portfolio management strategy can be undone very swiftly if behavioural traits provoke the wrong actions. 

It is vital that wealth managers not only understand this and their important role in achieving it but are equipped with the right tools to do so effectively.

That should mean making more and better use of available technology to better understand client behavioural needs through detailed personality and suitability assessment.

It is worrying when wealth managers themselves admit their suitability processes and systems are not up to the task. Advisers, and their clients, deserve better tools that can withstand the rigours of modern life.

Many detailed and time-intensive cashflow modelling tools are far too front-heavy, used at the start of the relationship, but then frequently ignored in cursory annual reviews. At the start of the COVID-19 pandemic, the financial circumstances of all advised clients changed substantially over a period of weeks. Cumbersome tools and annual review processes were inadequate to respond. Life changes fast; tools should reflect this. 

It is encouraging that wealth managers recognise there is an issue with their systems, but it will be more encouraging to see how they address the issue given that there are solutions available.

The right investing decisions are not about financial circumstances alone, but financial personality too, and we ignore that at our peril. Emotions and personality are at the root of most of the common mistakes wealth managers see and need to be factored into how advisers support their clients.

Greg B Davies is head of behavioural finance at Oxford Risk.

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