Behavioural finance
13 June 2022
By Alexander Joshi, London UK, Behavioural Finance Specialist
With uncertainty abounding and traditional allocations to equities and bonds struggling to produce desired returns, investors may need to adapt their approach. However, an optimal allocation is only optimal if it is adhered to. We discuss ways to stick to the plan when markets become trickier to navigate.
Investors may need to change how they allocate portfolios in response to the prospect of more muted returns, for example, by perhaps considering allocating to illiquid assets.
However, an optimal asset allocation is only optimal if it is adhered to, across the market cycle. Investors that deviate from their allocations – for example by increasing portfolio turnover in response to uncertainty – can find that they negatively impact their portfolio returns.
In this article, we examine key reasons why investors deviate from the most appropriate asset allocation for them, and discuss ways to stick to your plan even if bumpy markets test your resolve.
The global economy is facing a range of headwinds that have seen sharp falls in many markets this year. Investors aiming to invest more can hold off doing so during particularly volatile periods. For those already invested, actions may typically include reducing the proportion of risk assets in a portfolio, or in extreme cases selling their investments.
For many investors who want to act in tough times, market timing can look appealing. If an investor believes that the market outlook may worsen, then why not sell and get back in at a lower entry point? The problem is that timing is extremely difficult and its only with hindsight that you guarantee success.
In reality, many investors see markets move against them when they are out of them and then return at higher entry points. Alternatively, they may struggle to be comfortable with redeploying capital (to get a better entry point, the situation needs to have worsened, which emotionally may make it even harder to invest) while inflation eats away at their capital.
During volatile periods, investors’ emotional time horizons can shorten, as the here and now becomes the focal point. A shorter-term perspective can raise the perceived riskiness of investing – the probability of experiencing a loss in short periods is higher – which can lead to actions that may provide short-term comfort, but result in diverting from the plan to protect and grow wealth over the long term.
The risk is that making portfolio decisions in times of emotional stress can exacerbate behavioural biases in decision-making, possibly hitting returns. Bear markets can be the most challenging for investors due to taking poor, reactive decisions that have lasting consequences.
For those not fully comfortable with the idea of holding an investment portfolio through especially volatile times, it may be helpful to think about the concept of ‘anxiety-adjusted returns’, or the returns that an investor is comfortable with for a given level of emotional pressure.
Given our view that it is time in the market which matters more than market timing for long-term success, the best portfolio for an investor is one that is held across market cycles. Strategies such as phasing-in investments may be a helpful way to be more comfortable with getting invested.
Investors with concerns about the impact that changes in the economic and market outlook might have on portfolios may wonder what can be done to help them stick to their long-term plan.
The key is to make changes to investments while keeping a high enough allocation to risk assets so as to not alter the long-term returns potential of the portfolio.
One such approach is the use of hedging strategies, which allow an investor to stay invested in a way that also reflects (and positions for) concerns about how the core investment strategy will be affected. Use of put options, foreign exchange, and structured products are among examples of approaches that may protect against falling markets.
A core-satellite portfolio approach to investing can allow an investor to strike a balance between a long-term approach to investing, while allowing tactical tilts to the portfolio to be made in the short term. The bulk of the returns are generated by a core asset allocation, and a smaller satellite portfolio allows for more opportunistic trades.
A well-diversified portfolio can mitigate the impact of tail risks and reduce the volatility of returns. In the face of uncertainty, and risks which we do not even know about, the best protection is probably to invest in a range of assets.
Such a portfolio, for example holding quality companies with strong balance sheets and pricing power, means that events at the macro and market level may not fully affect an investor’s own portfolio. Weak economic news can make us fearful about the potential effect on our portfolio performance. However, much of the news may be noise for those that follow a robust investment process which produces a well-diversified portfolio of quality assets built for the long term.
There is also an additional emotional benefit from diversification. By insulating a portfolio from volatility, an investor may insulate themselves from the emotions that volatility can induce, which may make it easier to hold an investment portfolio when things are not going exactly to plan.
Additionally, as discussed in May’s Market Perspectives, having some illiquidity in a portfolio, perhaps by trying to harvest illiquidity premia by investing in private markets, could support good long-term investment behaviours.
As humans we like familiarity, which is mirrored in many investment portfolios that may be biased towards a particular region, or asset class. Familiarity is typically equated with lower risk (“I know the region”). We remind investors that a home-biased portfolio is more concentrated, which actually increases rather than decreases risk.
At a time where there are many possible headwinds for markets, some investors may consider the importance of having an allocation of cash for liquidity needs, but also for protection, as well as possible deployment at attractive entry points.
We remind all investors about the importance of striking the right balance. Too little liquidity can put an investor under pressure during times of market stress, but too much can be costly due to the costs of inflation – both from foregone returns as well as real erosion of capital.
Due to a heightened sense of risk or rising risk aversion for many investors when markets are particularly volatile, many may fear adding to or maintaining risk allocations. The result is holding too little for one’s level of risk tolerance and capacity. This could put reaching your goals at risk.
While the future can never be predicted, perhaps some reassurance can be provided by history. Over two consecutive years, equities have outperformed cash and UK government bonds 69% of the time. Over a ten-year period, this rises to 91% (see table).
It is important to recognise possible opportunities that arise in different market conditions. Such periods can offer more attractive entry points for investors with a long horizon.
Remember that long-run investment returns would be significantly lower if it wasn’t for these more challenging periods. Such periods occur frequently, but should not stop an investor from reaching their long-term goals if they can see them through.
We end with some considerations for investors as we go into the second half of the year:
This is a testing time for investors. However, history shows us that those who get, and stay, invested through these periods have the best chance of earning the returns needed to reach their long-term investment objectives.
This month we take a look at the major trends at play in the financial markets and the implications of surging inflation, central bank rate tightening, and slowing economic growth prospects. We also look at how private markets might be needed to bolster diversification, and what investors can do to limit the effect of what may continue to be a volatile end to the year.
