Decision making and investor behaviour

Pre-tax cash has yielded returns above that of the South African market over the last 4-years, and certain offshore markets this year. As expected, investors, particularly retired clients, are asking themselves whether they should switch their portfolios into cash. This makes common sense. We are trying to maximise our returns, at a level of risk, so why not switch to an investment with a higher return and lower risk?

When markets are delivering below average returns, it is important to pause and revert to first principles by asking a few key questions regarding our investments.

• What is your primary reason for being invested?
• What are your goals or objectives, and have they changed?
• How long is the review period you are assessing?
• What is your investing time-frame?
• If you are in an actively managed fund, what has the market done?
• Has your risk profile or tolerance for risk changed?
• What are you most concerned about with the negative return? The short-term loss, or not being able to achieve your retirement objectives?
• Do you believe these returns will continue?
• What does historical data on equity and cash returns, as well as market timing show us?

If your goals, objectives, or risk profile haven’t changed, then the best decision is usually to do nothing. Because the only change is the markets-which we don’t control. All we control is our behaviour and response.

But investors, and advisers, must still be mindful of the behavioural biases that humans experience in the face of such uncertainty.

By way of example, a risk-averse investor is an investor who prefers lower returns with known risks rather than higher returns with unknown risks. Conversely, a risk seeker is a person who is willing to take more risks while investing in order to earn higher returns. Thus a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into an equity portfolio that may have high expected returns, but also involves a chance of losing value.

What we see in practice, however, is clients will exhibit risk seeking behaviour when markets are rising, and risk aversion when markets are flat or falling. Investors decision making is swayed by emotions and biases, which will trip up our thinking resulting in lower long-term returns.

To counter this behaviour, we need to prepare our clients for market swings, through education and by improving our decision-making ability through a systematic, or rules-based approach to our investments. The catch is that we are not omniscient. Our process won’t work all the time, and it is easy to abandon the system the first time it fails

As advisors, I think we need to be more aware of the behavioural traits that all clients may exhibit, as well as those that an individual client may be vulnerable to. The more we understand what drives a client’s investment behaviour, the better equipped we are when they start to behave in a particular way.

If we can develop systems or processes to bypass this return destroying behaviour, we will be able to offer significant value to our clients. Preparation and process are more important that prediction. I’ll try put down some thoughts on that in the next week.