Financial decisions are driven as much by emotions as by economics. Investors’ fears, biases and behaviours regularly destroys wealth rather than building it.
We explored the reasons why in part one of this series, and here we explore ways to educate and work with these innate biases that all investors carry.
Financial advisers have a key role to play. They mentor, coach, and educate their clients, but this support can only go so far.
The sheer number of potentially poor decisions available to investors makes it impractical for advisers to provide one-on-one support to every client.
Investors need a goals-based investing framework that can also help protect them from common biases such as anchoring, loss aversion, short-term bias, and herding.
A goals-based investing framework
Creating better client investment behaviours requires advisers to use a framework that is robust, repeatable, and scalable, which involves:
• Raising client financial literacy.
• Applying risk benchmarks that better reflect client behaviours and market dynamics that allow advisers to tailor portfolios to individual client goals.
• Aligning and prioritising investment goals around client values.
Financial literacy has an undeniable role to play. The more knowledge people have, the more they will understand the gyrations of markets and be able to stay the course. The role of advisers and online financial tools is crucial. Studies suggest around 8.5 million adult Australians – or about 45 per cent – are financially illiterate.
Risk benchmarks and client goals
Many traditional portfolios are built to track benchmarks which have little relevance to clients. Portfolios that track capital market benchmarks or strategic asset allocation benchmarks are arbitrary compared to their real-world goals and ways of thinking.
Clients define their goals and risks in more tangible terms. (Innova’s business was set up with this principle at its foundation.) Different goals have different risks and time frames based on factors such as stage of life, wealth, family, and values.
Yet the academic world typically defines risk as volatility, which is reflected in a client’s risk tolerance measure. Risk is far broader.
It can include the risk of a maximum drawdown, average drawdown, poor decision making due to behavioural biases, the probability of a loss, and the risk of a client not achieving their goals.
Bucketing: academic theory versus the real world
Mental accounting is another behavioural bias that more accurately reflects the way clients think about their goals and risk. While it can lead to poor decisions, it can be harnessed in a positive way through a bucketing strategy:
• Safety, or Short-term bucket to fund immediate and short-term expenses and for safety in the event of a market downturn: Primarily low risk or conservative investments and cash, this covers immediate needs, such as emergency funds or essential retirement expenses. For accumulator clients, this would be a first home deposit, life and TPD insurance. This low-risk allocation helps clients feel secure.
• Lifestyle, or Medium-term bucket to fund lifestyle goals over the next 4-10 years: A portfolio invested in assets which blends growth and safety, this bucket meets clients’ discretionary goals, such as travel or home renovations, or increasing costs like children’s/ grandchildren’s school fees. Regarding younger or accumulation clients, income protection insurance would be used to protect their lifestyle.
• Future, or Long-term bucket to fund future needs more than a decade away: This portfolio is invested in growth assets to fund long-term aspirational or legacy goals, as well as to address longevity risk. Market drawdowns and gyrations should be less relevant, and a focus on long-term achievement of goals the more appropriate risk measure.
It’s true that blending these three buckets into one portfolio – which may appear similar to a traditional ‘balanced’ fund – would likely generate the same total return. But people react differently when they see their large single portfolio under pressure. During the Covid downturn in March 2020, some large super funds recorded outflows to cash as high as 3-4 per cent of funds under management, while one medium-sized fund posted 8 per cent outflows to cash. Those investors paid a hefty price for giving into behavioural biases such as loss aversion given markets quickly rebounded.
More accurate modelling
Linking different buckets of money to tangible objectives can reduce the emotional impact of market volatility or downturns.
It is easier to ride out a market downturn safe in the knowledge that a short-term bucket can fund expenses for a few years while the long-term bucket has time to rebound.
These buckets can be modelled using a goal simulator application, such as the one Innova offers. It can forecast average, best, and worst case scenarios for each bucket, which also helps moderate client expectations and keep them on track. 
It allows for a more nuanced approach. Goals can be re-framed in highly specific ways to help manage the risk of behavioural biases.
This goals-based framework empowers clients to make more informed decisions, avoid common biases, and stay focused on their long-term objectives. This approach not only benefits clients but also enhances the adviser-client relationship.
Listen to Innova Asset Management’s four-part Behavioural Investing Series featuring Patricia Garcia,
Dr. Katherine Hunt, David Bell and Dan Miles at: https://ensombl.com/series/ensombl-advice-australiapodcast/bis/.
FOR A DEMO AND A FREE TRIAL LOGIN OF OUR GOAL SIMULATOR, CONTACT OUR SALES TEAM:
Neil Pattinson
Email: npattinson@innovaam.com.au
Phone: 0439 900 280
John Li
Email: jli@innovaam.com.au
Phone: 0451 030 941
