This article appears in the November 2020 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.
New research reveals that wealthy investors may have fundamentally different motivations and beliefs about investing than less affluent clients do.
A research paper from a pair of academics — James Choi, finance professor at Yale University’s School of Management, and Adriana Robertson, head of research and policy at the University of Toronto’s Capital Markets Institute — provides rare empirical insight into the investing attitudes of the wealthy.
The research, published in October by the U.S. National Bureau of Economic Research (NBER), examines what drives investors’ decisions. The paper notes that it’s not possible to run controlled experiments in this area, and efforts to deduce investor motives from financial data typically don’t reveal clear explanations for the decisions investors make.
Instead, Choi and Robertson asked high-net-worth (HNW) investors directly about the beliefs and motivations behind their investment decisions.
The study examined almost 2,500 American investors who held at least US$1 million in financial assets (not including real estate holdings or business assets) each. Eighteen per cent of the survey participants had US$5 million in financial assets and 4% had more than US$10 million.
On average, the survey participants held 53.3% of their assets in equities, 15.4% in bonds and slightly more than 20% in “near-cash” assets (11.1% in actual cash and 9% in term deposits and/or money market funds). Average allocations to other asset classes — including real estate, structured products and financial instruments such as futures and options — were smaller.
The research found that the top factor in determining HNW investors’ allocations to equities are the recommendations they receive from their investment advisors, followed by time horizon, personal investing experience and the prospect of macroeconomic and personal health risks. The lowest-rated factors include fear of market losses; advice from friends, family or the media; and a desire to get richer than others.
Wealthy investors also said they aren’t motivated by conventional wisdom when it comes to equities allocations. For instance, few reported that their allocation decisions were driven by “rules of thumb” about portfolio mix and diversification, such as the 60/40 rule.
In a separate study, Choi and Robertson found a significantly different set of motivations for typical investors’ equities allocations. The researchers asked investors in more typical households some of the same questions, using a sample of more than 1,000 Americans.
That research paper, published by the Journal of Finance in February, found that the general population’s top factors for determining equities holdings are time until retirement, the prospect of health-care expenses, the need for cash to cover routine household expenses, the risk of losing a job and macroeconomic risk: “The typical household’s asset allocation is much more driven by discomfort with the market, financial constraints, and human capital considerations.”
In addition, typical investors’ lack of trust in the investment industry and lack of investing knowledge are important determinants of asset allocation, the research found. For the general population, professional investment advice was far down the list of factors determining equities allocations, ranking 23rd.
Not only do HNW investors rely much more on professional advice to steer their investing decisions, they also appear to have a high level of confidence in their ability to pick winners, the NBER paper states.
“Many wealthy investors believe that they can identify superior investment opportunities,” that paper states.
For example, the research found that HNW investors who choose active investment management strategies do so primarily because they expect these strategies to deliver higher returns than a passive strategy would. HNW investors also are confident they can identify active money managers capable of outperformance. The research found that 42% of wealthy investors believe that a fund portfolio manager beating the market in the past indicates that the manager has superior stock-picking abilities.
“Overall, the pattern of responses suggests that a significant amount of active investing through funds by the wealthy is driven by [wealthy investors’] belief that they can identify managers who will deliver superior unconditional average returns,” the paper states.
Further evidence that HNW investors believe they can beat the market includes the fact that almost half of the investors with concentrated portfolios — in which at least 10% of an investor’s net worth is invested in a single stock — said they believe a particular stock will outperform the market; therefore, they do not need a more diversified portfolio.
“The belief that the concentrated position is a superior investment seems to be the predominant motive for forgoing diversification,” the paper states.
Other possible explanations for large, concentrated holdings of single stocks — such as a desire for shareholder voting power, lock-up agreements and market signalling — were much less popular with HNW investors.
In addition, the research found that HNW investors don’t fully believe in the basic axiom that risk and return are positively correlated. When survey participants were asked about their return expectations for a variety of stocks, the paper reports, wealthy investors’ beliefs “about the normal relationship between a stock’s characteristics and its expected returns often do not match historical experience.”
For example, wealthy investors said they expect high-momentum stocks to have both lower returns and higher risk than low-momentum stocks. The only instance in which wealthy investors expected a positive relationship between risk and return was when considering growth versus value stocks: HNW investors expected lower risk and lower returns from value stocks.
Given that the research is based on surveys of U.S. investors, Robertson says, she can’t be confident about the extent to which the results would be echoed by HNW investors in Canada. However, her “hunch” is that the results “would be fairly similar.”