“The four most dangerous words in the world of investing just might be ‘this time it’s different’. When it comes to making investment decisions, consistency is key, and making emotional decisions in reaction to extraordinary events often destroys market value for investors.”
These are the cautionary words of Paul Nixon, head of behavioural finance at Momentum Investments, speaking at a media webinar, which unpacked the findings of the Momentum Investments and Oxford Risk Noise and Investment Advice Study.
Nixon highlights that investors generally conform to one of five switching behaviour patterns that often dictate how they would make investment decisions, especially under stress. “These archetypes include assertive, anxious, contrarian, avoider and market timer. What is important to note is how last year’s market trends really brought out these archetypes. For example, one can see that the majority of the investment switches last year were made by the avoider-type investors, but anxious investors lost the most because they need a lot of confidence before re-entering markets and, in this case, missed the market recovery completely. ”
Nixon further points out that few people doubt the value that financial advisers add in getting clients to accumulate, protect and ultimately distribute their wealth. “However, financial planning is a professional service just like medicine and law. These fields too clearly add tremendous value, but are also prone to the inconsistencies inherent to any profession where human judgement sits at the centre.”
“A subject that is becoming extremely topical for advisers in particular, is the notion of ‘noise’. Even if you aim to remove as much bias as possible from the advice that a firm might give its clients, there may be variations in advice that the individual adviser gives to individual clients (possibly influenced by factors such as emotion). However, it is vital that the advice received by every individual client, remains as close to their specific objective needs, and not the characteristics of the adviser. Consistency of advice is also crucially important for any advisory firm. This is why being much more aware of noise and how to combat it, is so vital.”
One of the interesting findings of the study was that the conventional methods of assessing risk of individual investors, is subject to a fair amount of noise. “Advisers in the study were asked to assign a level of risk to each client, on a scale of one to five. We found that even though the clients remained the same, the levels of assigned risk had a tendency to vary quite significantly from adviser to adviser. Equity allocations for these clients also varied, with clients at risk level three, for example, being given equities of anywhere between 10% and 75% of their portfolio. This does seem to be a high level of variation.”
According to Davies, the outcome of the study provides several remedies for inconsistent behaviour and reduces the risk of such wide variations in the advice process. “The answer to a lot of this is to acknowledge that processing a lot of data and coming to a consistent answer, is not something that we humans are very good at. At the same time, any client situation has to involve huge amounts of information. If there isn’t a system to capture that information, and arrive at a reliable answer, we will always see noise creeping in. If we want to do this better, behavioural technology will have to play an increasingly important role in how investment firms test their strategies and decisions.”
Davies also points out that research into noise in the investment world is only just getting off the ground. “We believe that the financial industry still doesn’t have any idea how big or small this problem really is, which is why more of these types of studies will need to take place.”
“In the information age the value of advice has shifted from a transactional relationship of choosing the best product to a long-term relationship where the financial planner acts as a coach and mentor. For the financial planner to remain relevant in the future, they need to upgrade their human and technological skill sets,” David Kop, Head: Policy and Engagement at the Financial Planning Institute of Southern Africa comments.
In closing, Davies says that there are many lessons to be taken from the nationwide lockdown period that would be useful to create a better investment atmosphere. “Ultimately, we are likely to face similar periods of uncertainty in the near future. It is therefore important to start recognising noise when we see it, and adjust our approach to advice accordingly,” he concludes.
More of the study will be unpacked in next week’s newsletter.