Knowing your financial personality is valuable information, but by itself it is not enough to improve long-term performance. It is essential to use what we now know about investors’ behavioural tendencies to make targeted and practical changes to portfolios, with the aim of providing the emotional insurance that each investor requires to maintain their commitment to the long-term strategy.
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Some of the changes we aim to implement may be at odds with traditional theory; however, a deviation from classical investment techniques is not ‘wrong’ if it helps investors to overcome greater costs elsewhere. It will increase anxiety-adjusted returns.
Here, we take you through some of the interventions that we would consider making based on the outcomes of our work with each client.
The table below lists and categorises some of the targeted ways of keeping our emotional reservoir full, and indicates the potential effectiveness of each in mitigating the main costs that investors impose on themselves over the journey. The middle columns of the table show how effective each action can be in mitigating the behavioural costs due to (a) reluctance, and (b) the behaviour gap. A single ‘+’ means ‘slightly effective’; ‘++’ is ‘effective’; and ‘+++’ is ‘highly effective’. There is also one cell with ‘--’, which is there to indicate that, while locking investors into low liquidity assets is somewhat effective in reducing the costs of the behaviour gap, it can be quite harmful in that it may make investors even more reluctant to invest.
In the sections below, we discuss each category of interventions in turn, and give some idea of the practicalities and effectiveness of each.
Figure 8: Practical actions to provide emotional insurance
We can take control to some extent by improving our knowledge. By knowing more about a wider range of investments, we become more comfortable with asset classes and markets. While education alone can only accomplish so much – i.e., knowledge does not eliminate our need for comfort – education can nudge us toward good actions, particularly for less-confident investors with low Perceived Financial Expertise (this is a factor that we will discuss in more detail later).
To manage one’s wealth effectively we know that 100% of long-term capital should be invested and that you need to be committed to the journey. An extreme way of preventing short-term emotional responses is to lock yourself into investments so that in times of turmoil you can’t respond by jumping ship – often at the worst time from an investment point of view. However, this strategy requires considerable self-awareness, and is not for the faint hearted as it removes your ability to achieve comfort at precisely the time you’re most anxious! For this reason we don’t advocate liquidity constraints as a solution for low Composure investors. Better to turn to the range of other options (some of which we discuss below) that improve decision making by seeking comfort, rather than constraining options.
“the best solution is to only sacrifice financial efficiency for comfort in a planned way, and with full awareness of the trade-offs”
The lower the risk in your portfolio, the smoother the journey, and the lower the demands on your emotional liquidity. As a result, you’re going to be less tempted to sacrifice long-term performance for short-term comfort. The simplest way to purchase short-term comfort and reduce anxiety is to reduce risk (provided, of course, you have come to grips with the reduced opportunity for growth that comes with it).
Increasing cash levels and choosing a less risky asset allocation will reduce reluctance and the behaviour gap, but this is a very blunt tool that imposes high costs on long-term performance.
For the majority of investors it is better to be fully invested in the markets and find more efficient ways to achieve comfort. Fortunately, there are ways of precisely targeting the risks that give rise to short-term discomfort, while minimising the drag on long-term performance.
These are interventions that specifically target short-term downside risk, without a wholesale reduction of risk in the portfolio. They may include the use of derivatives to dampen volatility; dynamic portfolio insurance; use of active fund managers who perform particularly well in down markets; and structured products which access risky underlying investments, but with some downside mitigation. These all cost something, but because they specifically target aspects of short-term performance that most induce anxiety, this cost comes with significant emotional benefits.
Smoothing focuses on the experience of the whole journey. However, some investors are relatively calm through most of the journey, but worry intensely about the chance of calamitous market crashes. This is particularly prevalent for investors with low Market Engagement, who may avoid investing at all, for fear of experiencing a large crash. The targeted intervention for these investors is to purchase downside protection. This insurance will guard against the worst-case scenario and allow greater emotional comfort by removing the potential for extreme market loss and, as importantly, the fear of an extreme loss (anticipated regret).
Another means of persuading reluctant investors into the market is to engage them through a program of phased investment. Classical finance warns us against such strategies (known as dollar cost averaging) because they leave wealth un-invested during the phasing period and, therefore, drag down expected returns. This is true – phased investment is suboptimal when compared to theoretical perfection; but only slightly, and compared to the returns of an investor who is otherwise too nervous to invest at all, gradual phasing in is an effective way of purchasing emotional comfort cheaply.
During periods of stress, people seek comfort from others. Friends, family, colleagues, advisors and professional investment managers can all help investors through times of anxiety. However, this can be costly: at best you sacrifice some autonomy or pay management fees, but improve both your journey and your returns. At worst, you place your faith in poor advice, which offers a comfortable journey that goes nowhere, or worse. One crucial precondition for using others to improve your experience of the journey is that you have the personality that makes this possible. This requires a high Delegation score, unless the client may find that relinquishing control will just make them more stressed. As a result, involvement comes in varying degrees of intensity:
Discretionary management – delegating
Discretionary management can be a very effective way of imposing control at a relatively low cost because it yields returns that are higher than they would have been. In effect, by handing responsibility to a third party, the investor is buying pre-planned emotional insurance and greater expertise at an acceptable price.
Using advisors – the benefits of a second opinion
Seeking advice can help to ease the emotional burden of investing one’s wealth. A second opinion can reduce your inherent biases such as being overly optimistic, or too prone to investing in a particular sector.
Controlling information – focussing on the big picture
People have different appetites for information. Some can happily look at their portfolios only infrequently; others watch incessantly every day. Bearing in mind that effective wealth management demands a long-term approach, it can be discomforting and distracting to receive information too often. Limiting the frequency and detail of information makes it possible for investors to shift their focus from the expensive short term to a cooler medium- or long-term view.
Trading off efficiency for comfort
As we’ve stated, small inefficiencies can be beneficial if they help investors to overcome reluctance, or reduce the behaviour gap. However, the best solution is to only sacrifice financial efficiency for comfort in a planned way, and with full awareness of the trade-offs, to ensure that comfort is purchased as efficiently as possible.
Locking yourself into investments can be a dangerous way of preventing emotional responses to the short term. However, reducing liquidity not only prevents investors getting out of investments, it is also typically rewarded by higher returns – the liquidity premium – which repays investors for providing liquidity, and taking on the associated anxiety. For high Composure investors, this is a good way to boost returns, but for nervous investors, forgoing this premium and only entering highly liquid investments will help in maintaining emotional liquidity.
When investors have low Market Engagement, the inclination is to steer toward the comfort of what they know (familiarity bias) and local assets (home-country bias). They will then invest too heavily in familiar assets to the detriment of performance. The net result is a less efficient portfolio with its emphasis on local regions and industries, and its concentration of asset returns correlated with the investor’s employer, local economy and their personal income stream. In extreme cases this can be extraordinarily costly when employees pour their savings into shares of the company they work for (quite possibly the most easily avoided example of bad investing).
However, for those with low Market Engagement it can be very helpful to introduce some limited familiarity bias or home bias onto the technically perfect portfolio.
Deliberate action bias
When things go wrong and we find ourselves invested in the depths of a crisis, the temptation to act – usually to exit – can become overwhelming. However, selling at such times is one of the most costly financial decisions an investor can take. For someone strongly inclined to the action bias, inaction can make a stressful time even worse. In these circumstances a good strategy is to deliberately look for small changes that one can make to the portfolio, in effect, tidying up. Better a little action, mostly harmless, than costly capitulation.
One of the main considerations for a portfolio is whether it should be actively or passively managed. The choice should be guided by the profile of the investors. Should you use active managers who will hopefully beat the market, or buy cheaper index funds which don’t try? Should you stick which a cheaper static long-term strategic asset allocation, or a more costly and active tactical approach that attempts to improve performance by constantly adapting to the market environment? There are passionate advocates for both sides, but our Belief in Skill personality dimension gives a clear indication of which will make any investor most emotionally comfortable. At Barclays, we don’t take a dogmatic stance.
We maintain a full platform of both passive and active solutions, and aim to build portfolios that best suit the personality of each investor.
All of us can acquire the focus we need to invest successfully, but we need to put in the effort to construct a considered framework of rules and guidelines to govern our own investing behaviour.
One of the key reasons why individual investors systematically underperform professional investors is not that they are inherently worse investors, but simply that professionals have greater ‘self-control’ imposed on them through a strong set of institutional rules. To match this, individual investors can develop their own personal investment constitution, providing the rules that we often need to guide our behaviour in times of turmoil.
These rules need to be individually tailored to each investor’s circumstances, experience and knowledge. They can limit the proportion of wealth held in cash or short-term instruments, and set a time period in which to invest cash in order to avoid being underinvested.
They can fix levels of long-term holdings and the minimum diversification of the portfolio. A rule mandating a cooling-off period between the decision taken and the execution can also allow essential breathing space for reflection for big investment decisions. When markets are turbulent, rules can guide the investor to be deliberately inactive to avoid rash decisions. They can also set out triggers that will prompt the investor to rebalance the portfolio to maximise returns. And because it is a formal way of investing, the investor will find it less difficult to execute.