The investment industry is in the business of trying to achieve two conflicting aims: deliver portfolio returns that clients need to reach their goals; and avoid the volatility that could lead clients to panic and abandon their investment plans at the worst possible time.
For financial advisors crafting portfolios, these aims generally mean looking at clients’ wealth, goals and time horizon to determine how much risk each client can afford to take, then evaluating the client’s underlying tolerance to understand better the level of risk he or she is willing to shoulder without panicking during a market decline.
However, according to a 2018 report from Chicago-based Morningstar Inc. entitled “Using a Behavioral Approach to Mitigate Panic and Improve Investor Outcomes” and published in the Journal of Financial Planning, advisors would be served better by adding a third, more “behavioural” approach to help protect clients from themselves.
Standard portfolio construction approaches falter because the same tool – asset allocation – is used to address two fundamentally different problems: panic and insufficient returns, argues Stephen Wendel, head of behavioural science at Morningstar and author of the report. “It is not the portfolio that needs assistance; rather, it is the investor,” the report states.
The report details a simulation model of investor behaviour that was executed over every 120-month window from 1926 to 2015.
At the heart of the simulation is an extensional model of investor behavior using several stylized types of clients, ranging from those who invest according to an established glide path and never panic during downturns to clients who react sharply to a sudden drop in portfolio value or a cumulative drop over a specified period.
Each month in the model, the markets generated returns, which affected the value of the hypothetical portfolio. The hypothetical client then had the option of reacting to the markets and adjusting both the portfolio mix and the allocation of future contributions. The client also received income, contributed a portion of it to new investments and allocated it accordingly.
The model demonstrated how investor panic resulted in a loss of 8%-15% of assets over a 10-year period when the model used standard risk capacity-based asset allocations and risk preference-adjusted glide paths.
The starting point of such a behavioral approach is recognizing that the path to self-destructive panic selling occurs in stages, the report states. Investments are inherently volatile; when investors receive information about actual volatility, that triggers an emotional response and generates a decision that a change must be made, which, in turn, leads to portfolios being modified at an inopportune time.
The report highlights several methods of portfolio construction that could deter investors from making poor decisions, including using target-date funds, investment managers who limit downside risk and bucket strategies that separate short time-horizon investments from long time-horizon, higher-volatility options.
The report also suggests revisiting a client’s written financial plan during volatile times as well as creating”circuit breakers,” such as an agreed-upon delay between decision and execution or ensuring a spouse needs to sign off on significant portfolio changes.
By incorporating such behavioural tools alongside traditional asset allocation, retail investors could receive a net increase of 17%-23% in assets over 10 years, the report states.