A closer look at investor behaviour

Advisers protect their clients from a wide range of market risks: inflation, rising rates, illiquidity, currency, business, legislative change, and even their lifestyles. But the biggest risk clients need protecting from may well be their own behaviour.

It can be a bitter pill to swallow given clients are often successful people who have accrued above-average wealth, yet the evidence is clear. Several studies have now shown not only a predictable history of poor decisions under market pressure, but exactly which investors are most susceptible.

The latest academic study looked at one of the country’s largest super funds from 2017 to 2021, which covered the COVID crisis. Not surprisingly, it found a spike in defensive switches during the COVID-related market sell-off (and other minor market downturns).

While those investment switches represented a minority of investors, certain demographics were far more at risk. They were:

  • Aged 55 to 70.
  • Had higher account balances.
  • Previously made a choice away from the default option.
  • Tended to be more engaged investors.

A similar study following the Global Financial Crisis in 2009 looked at four large super funds’ data covering 135,400 individual decisions and found similar attributes: investors who switched options tended to be older and have higher balances.[1]

The wrong investment decision by this type of investor can curtail a lifetime of saving and, unfortunately, their switches had that affect, as shown in Figure 2 below. The worst result was an average 7 per cent loss for default option investors who switched during COVID but even those who switched outside of COVID lost an average 1.6 per cent.

Behavioural biases at work

There are multiple behavioural biases driving such irrational investment decisions.

“Our analysis shows that members are vulnerable to making bad investment decisions, which appear to arise from a combination of return chasing and poor market timing,” according to the study’s authors.

Return chasing leads investors to buy high and sell low – the opposite of what they should be doing. This also ties back to our understanding of how markets behave: momentum (or herding) is a such a strong force shaping short-term returns. Long-term valuations are also drawn back to the mean, so chasing returns after a strong period of performance already has a lower probability of paying off.

The separate switching study following the GFC also pointed to return chasing, highlighting how pervasive the bias is across all types of investors.

“The evidence of return-chasing is consistent across all funds, hence there is no evidence that the diversity of structure and content of the investment options available makes a significant difference. Nor, given that the funds have members across a wide range of industry sectors and employment types, is there any evidence that work sector or status has a significant impact on the likelihood of return-chasing.”

Another behavioural bias at work is loss aversion, particularly given the older age and higher balances of those who tend to switch. Loss aversion describes the way most people feel the pain from a loss far more than the pleasure from a gain. Retirees tend to be even more sensitive, according to a 2007 study by not-for-profit AARP (which represents older Americans) and the American Council of Life Insurers.

Even clients with an adviser can still make poor decisions.

The CFA Institute Investor 2022 Trust Study found that most clients advised to significantly or slightly increase risk/exposure to the market as COVID hit in March 2020 did so (75 per cent and 64 per cent respectively). However, a sizeable 21 per cent and 24 per cent respectively acted in the opposite manner, reducing risk. Given the unusual speed of the market rebound, they would have only locked in losses.

Two-pronged approach to keep investors on track

The two academic studies showed the same type of investor falling into the same pitfalls, even though the COVID crisis and the Global Financial Crisis were very different events. The pandemic was a non-market event that caused one of the quickest market falls and rebounds in history. The GFC produced a prolonged downturn that lasted years.

While no-one knows the exact timing and trigger of the next market downturn, or even crisis, advisers know that a significant proportion of older and wealthier investors will make poor decisions.

It requires preparation in advance to stop them – a financial plan that can withstand periods of poor performance and strong relationships to help clients maintain their strategy. But that isn’t enough – it also requires portfolios that can withstand the gyrations of the market rather than theoretical portfolios built on perfect forecasts.

[1] The main difference between the two studies is the older one found women were more likely to switch while the latest study found men were more likely to switch.

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