By: Paul Nixon, Head of Technical Marketing and Behavioural Finance at Momentum Investments
Following our instincts for investments often does not serve us well.
The effects of fear and greed on investment decisions and returns are often reflected in the form of a ‘behaviour tax’. A behaviour tax is a lower investment return as a result of an investor’s behaviour, like switching funds because markets are falling, compared to portfolios which are bought and held.
Momentum Investments recently published a white paper titled ‘Understanding the great forces that rule the world: A study on South African investor behaviour’, and developed a South African first: a segmentation of South African investors based on a risk-based analysis of the switching of their holdings in discretionary unit trusts.
The grouping of investors based on their risk behaviour is useful for several reasons.
Firstly, it allows for the effective linking of their risk preferences or risk tolerance (both stable by nature) securely with their long-term investment goals.
Secondly, a better understanding of the compromising nature of myopic risk behaviour (which places too much emphasis on the present and its related emotions) is key to understanding client and adviser behaviour, and, more importantly intervening accordingly at the right time to avoid the associated negative implications of these behaviours.
Ultimately, the point is to help investors avoid the harmful outcomes of their choices. Investors are prone to making short-term investment decisions that are not aligned with their long-term investment goals. The aim is to reduce the possibility of these decisions leading to a behaviour tax on the investor’s portfolio that contributes to disappointing investment outcomes.
There are three key hurdles to overcome. Firstly, a sound and objective basis for the accurate assessment of investor risk preferences or risk tolerance is needed. Theory suggests that these are both stable and long term in nature but measuring them accurately is something the industry has been battling with for some time and is of concern to regulators.
The second hurdle is that each investment fund’s history experienced places the investor at risk of making decisions being driven by their (changing) risk propensity. Simply put, their current tendency to take risk may have shifted out of sync with their long-term preferences due to recent experiences. Propensity to take risk is an emotional decision link to recent events and if used as the basis for choices can lead to inconsistent investment outcomes.
Either investors switch into safe assets in a market crisis which can result in poor returns when the portfolio is not timeously reinvested, or they may be tempted to take on more risk when markets are yielding more than their previous expectations – again leading to poor outcomes when these investment bubbles ‘pop’.
The final hurdle to overcome is a difficult one – the effects of time. Evidence reviewed in our study suggests that belief formation is a significant predictor of future behaviour and while an investor’s risk propensity is variable, it becomes increasingly difficult to influence over time as investment outcome experience builds.
If we as an industry are not successful at intervening from the early onset of investment outcomes, the challenge in getting investors to stick to long-term investment goals becomes increasingly challenging.
The goal remains to better align investors’ short-term decisions with their long-term investment goals, something that we at Momentum Investments remain committed to achieving through our outcome-based investing philosophy. By connecting to the outcome you want the client to achieve, the focus is on the end goal, instead of being disheartened by short-term underperformance that triggers switching.
The white paper is available at momentum.co.za, click here.