Striving to be a smart investor in the 21st century isn't easy. All of us face a bewildering array of product choices and information sources in an ever-expanding investment universe. The financial markets are volatile and unpredictable. There's also the question of deciding which asset management and financial advisory services are best for you, and how much you should be willing to pay.
On top of these external factors, your worst enemy as an investor may very well be yourself. Your biases and beliefs. Your fears or, alternatively, your bravado. Behavioural economics, the subject of this month's series of Morningstar Executive Forums, is the study of these personal tendencies and how to counter the negative impacts they have on the investor experience.
One tendency that can hurt investors is overconfidence, says Jason Stewart, executive advisor, financial services, with the consulting firm BEworks. "Most people believe that bad things are not going to happen to them. They won't experience either a family breakup, illness, some element of variability with respect to their employment income and the view that they can wait to engage in not only having sufficient savings but also financial planning, especially for retirement."
At the same time, Stewart added, investing is a daunting prospect for all but the most knowledgeable investors. "Self-control and rational choice actually tax us quite a bit, even on a basic shopping purpose," he said. "Layering that on to the complexity of the financial sector, we've got a whole series of things that make it incredibly difficult for all but people who are quite numerate, have sufficient income but also sufficient training."
Stewart was one of three panellists for the panel discussion held in Toronto, along with Steve Wendel, head of behavioural science for Morningstar, and Tom Bradley, president and co-founder of mutual-fund manager and direct seller Steadyhand. The Oct. 18 event was moderated by Michael Keaveney, the Canadian head of Morningstar Investment Management.
For individual retail investors, says Wendel, the greatest danger by far is panic selling during a down market. Getting overexcited and trying to chase fads is also harmful, "but it generally pales by comparison to leaving and not being in the market when the upswing comes back."
Investors are prone to what behavioural economists refer to as "recency bias," Wendel says. "For the everyday investor, the best predictor of what's about to happen is what has just happened. So it is a perfectly rational and thoughtful thing to do to say: My portfolio has just dropped 10%. I'd better get out now before it drops another 10." Wendel notes that while this way of thinking would be reasonable in most situations in everyday life, it's detrimental for investors since market behaviour "is fundamentally opposite to everyday behaviour."
As a result, investors as a whole experience a behavioural gap. This is a shortfall in returns which is the difference between the market returns and the returns that they experience in their own portfolios.
As a practitioner, Steadyhand's Bradley says the biggest issue he's faced over the past 35 years in Canada was the behaviour of many investors during the severe 2008-2009 bear market. They got out sometime in 2008 or 2009, or they got out in 2011 because they expected another severe downturn. As a result, Bradley added, Canadians as a whole "missed to a large part or were seriously underinvested in this bull market."
Another contributor to the behavioural gap, said Bradley, is the disconnect between investors' long-term horizon and their short-term thinking about the financial markets. "The disconnect between what people's goals with their money are, and how they make decisions is just so huge, in the sense that their goals for the money are usually 20, 30 or even 40 years out, and yet their decisions are hyper-short-term."
Morningstar's panelists offered various means that industry participants and individual investors can employ to improve investor outcomes:
Ensure that your portfolio is fully diversified. It's all right to act on a tip or insight with respect to a specialty investment, says Bradley, but this should always be done from a base of being fully diversified. That means owning different types of assets, having exposure to different countries and regions and industries. "I know it's very basic but It prevents and deals with at least a lot of our behavioural biases."
Choose the right investment tools: As Wendel notes, there are a wide range of investment products and techniques available to individual investors and their advisors. For example, investors in target-date funds are less prone to panic during market downturns because these funds are a "set it and forget it" type of product. "It's not fundamentally about what investments there are," says Wendel. "It's about how it's sold to the investor and what their expectations are."
Clarify the investment goals. In getting to know an investor's goals and personality, Stewart recommends combining in-person interviews and online questionnaires. There's a "tremendous anonymity effect" online, he says, resulting in much more disclosure and better information for the advisor. He adds that this process also helps individual investors in clarifying and specifying their goals. As part of the goals-setting process, says Bradley, clear distinctions should be made between investing for shorter-term goals such as saving for a college education or a down payment on a home, and longer-term goals such as saving for retirement. "Help frame the differences between those pots of money."
Make investing convenient and automatic. To alleviate stress and information overload, says Stewart, investors and their advisors should look for ways to automate some investment decisions. "If our attention is strained by far too many things asking for it, the more we can make good behaviour automatic the better." Bradley says pre-authorized services such as regular contributions of new money and automatic portfolio rebalancing prevent investors from "overthinking" their investments. "They don't think about it," he says. "They don't try and time it."
Don't check portfolios and performance frequently. The more often people look at their portfolios, the worse off they are, according to Wendel. "It warps behaviour to look at the day-to-day and for that matter even the month-to-month changes in someone's portfolio," he says, adding that advisors should encourage clients to take a calmer, longer-term view. But during market downturns, says Stewart, it's important for advisors to communicate with their clients and to convey the message that the long-term tendency of market returns is positive.
Reframe emotions about market risks: The sensation of excitement is quite similar to the sensation of anxiety, says Wendel. For example, a market downturn can provoke anxiety but it can also be viewed as an opportunity. As Wendel put it: "I think, markets down. Great! Opportunity for profit." The fundamental data doesn't change. What does change, says Wendel, is how the data is interpreted.
