Behavioural finance has an increasingly central part in conversations about investment risk, since managing emotional responses plays a key role in maximising returns.
Greg Davies, Head of Behavioural Finance at Oxford Risk, explains why managing the investor is just as, if not more, important as managing their investments if the best outcomes are to be secured.
“Suitability” – ensuring that investment solutions are right for each individual client’s circumstance and preferences – is the all-important concept in the investment world, meaning the necessity of matching the risk an investor is both willing and able to take on to that actually represented by the investments proposed to them. But while that sounds relatively simple, there are nuances it is vital for investors to understand. Willingness and ability to take on investment risk are two quite different things, and there are different types of ability as well.
In addition to the purely financial ability, each investor has a certainn emotional ability to assume risk. This
behavioural capacity is what determines how comfortable they are on their investment journey and, in turn, how well their plans will “stick”
Willingness is best represented by “risk tolerance”, the long-term and pretty stable psychological trait that can be measured reliably by psychometric tests. Financial ability to take on risk, meanwhile, largely concerns a person’s financial circumstances. Here the questions are more about what is being risked in that person’s lifestyle and financial plans if an investment should go awry, leading to a quantified and dynamic measure of “risk capacity”.
This conception of ability to take on risk is not complete, however. In addition to the purely financial ability, each investor has a certain emotional ability to assume risk. This behavioural capacity is what determines how comfortable they are on their investment journey and, in turn, how well their plans will “stick”.
An advisor can devise an excellent investment strategy; indeed, it could be the “perfect” portfolio for the individual in theory. Yet if the person can’t stick to the plan or feels sick while doing so, then sub-optimal behaviours leading to sub-optimal outcomes are the likely result. Emotional ability is not about financial circumstances alone, but financial personality too and we ignore that at our peril.
Your wealth manager should be deploying several techniques to get to know your financial personality, as well as staying current with your risk capacity and tolerance in the purely financial sense. However, knowing yourself and how your traits are likely to make you want to react to events is a wise course for any investor – and particularly those braving the markets alone as a DIY-er.
To demonstrate the importance of behavioural capacity, let’s compare some hypothetical investors who, while they have the exact same risk tolerance and capacity, differ on three key behavioural traits: composure, confidence, and impulsivity. These are three core factors Oxford Risk’s multi-dimensional assessment of financial personality brings to light and which give investors and their advisors vital help in heading off unhelpful behaviours.
Investor A displays low composure, low confidence, and high impulsivity. This is an unfortunately common behavioural timebomb that often leads to costly mistakes like cashing out when markets fall.
In order to manage Investor A’s tendency towards low composure and high impulsivity, firstly their plan should be rooted in simple pre-set rules that are made in cooler-headed times to offer a clear course of action when emotions are running high.
In order to manage Investor A’s tendency towards low composure and high impulsivity, firstly their plan should be rooted in simple pre-set rules that are made in cooler-headed times to offer a clear course of action when emotions are running high
Secondly, Investor A’s need to take action in times of turmoil can be addressed by the compilation of investment to-do lists which prescribe constructive actions, rather than “sell everything”.
Thirdly, Investor A could consider automatic investing. This drip-feeding of capital into the markets not only lessens the need to make decisions and so lowers stress, it also prevents undue focus on a single investment and the kind of short-term performance checking that provokes knee-jerk reactions.
Though they share high impulsivity, Investor B’s high composure and high confidence makes them the polar opposite to Investor A. They can still get themselves in as much trouble, however, if they do not monitor and mitigate any potential overconfidence and their potential to miss engaging with their investments when it is right to do so.
One key action would be for Investor B to stick to pre-set times to review their portfolio. This not only helps with focus but more importantly reduces the chances of snap decisions being made due to overconfidence.
One key action would be for Investor B to stick to pre-set times to review their portfolio. This not only helps with focus but more importantly reduces the chances of snap decisions being made due to overconfidence
Secondly, Investor B might look to invest in some less liquid investment products that force a longer-term outlook.
Thirdly, and no less important, is the need for Investor B to get the right kind of communications from their wealth manager. These should be frequent but high level, only adding investment details when necessary for making a decision.
Investor C displays another all-too common mixture of medium composure, low confidence and low impulsivity which often manifests as apathy and staying on the side-lines too long. Here, the plan should focus on making investing feel manageable, relevant and urgent in a good way.
Investor C should probably avoid poring over general daily market news, firstly because this amplifies the perceived complexity of investing in a really off-putting way and secondly because it’s simply not likely to be relevant to the individual investor.
Investor C displays another all-too common mixture of medium composure, low confidence and low impulsivity which often manifests as apathy and staying on the side-lines too long
What is helpful to people like Investor C are stories of particular investments that emphasise interesting elements and hook them in to want to find out more.
Finally, defeating procrastination has to be part of the plan. Investors with these traits often really benefit from shortlists, defaults and deadlines that prevent action being continually postponed. It goes without saying that an advisor can play a hugely valuable role here.
The real point to all this is that managing the investor is just as, if not more, important as managing the investments themselves. A carefully composed portfolio management strategy can be undone very swiftly if behavioural traits provoke the wrong actions. On the flipside, lessons learned, or mistakes avoided, can compound even more dramatically than financial returns.
A carefully composed portfolio management strategy can be undone very swiftly if behavioural traits provoke the wrong actions
Investors working with an advisor have the inestimable advantage of having someone well-versed in these matters to help them towards self-knowledge and a plan which negates their less helpful traits. The DIY investor has more work to do, but there are tools and techniques which will help you discover what makes you tick as an investor and make better decisions as a result.
The investment strategy and financial planning explanations of this piece are for informational purposes only, may represent only one view, and are not intended in any way as financial or investment advice. Any comment on specific securities should not be interpreted as investment research or advice, solicitation or recommendations to buy or sell a particular security.
We always advise consultation with a professional before making any investment and financial planning decisions.
Always remember that investing involves risk and the value of investments may fall as well as rise. Past performance should not be seen as a guarantee of future returns.