The Value of Advice – Understanding investor behaviour

06 Nov 2023

From AdviserVoice - this CPD article is proudly brought to you by Russell Investments

Understanding investor behaviour can assist advisers in value-adding client management.

Investor behaviour cannot always be anticipated, particularly during periods of significant change and market volatility. More than ever, advisers are helping clients navigate the emotional side of their financial affairs as much as the technical aspects. This article, proudly sponsored by Russell Investments, examines the value of advice and within that, the importance of understanding investor behaviour.

A series of unexpected events over the past few years – COVID-19, the Ukraine war, US banking crisis, surging interest rates and inflation and now unrest in the Middle East – have tested nerves time and again as market volatility pushed the values of portfolios temporarily lower.

It is less than 20 years since the global financial crisis (GFC) rocked markets and its impact remains etched in the memories of many people. Advisers played an important role then and continue to do so; to ensure their clients understand that the GFC, COVID-19 and geopolitical unrest have proved that an investor with a properly constructed portfolio and a long term view can weather extreme periods of volatility.

These last three years have provided a clear demonstration of the importance of remaining invested through thick or thin. An investor who fled for the exits in mid-March 2020 when the pandemic emerged would have had a difficult time to find the best re-entry point, with no real market “dips” to take advantage of. This is where the value from your behavioural guidance shows up on the bottom line.

These lessons prove crucial in an environment during which official rates have risen from emergency lows to today’s 11-year high. Many investors are learning for the first time that high inflation erodes gains from cash investments to push real returns lower. Others are realising that bull markets don’t run forever.

What is behavioural finance?

Behavioural finance posits that rather than being rational and calculating, investors often make financial decisions based on emotions and cognitive biases^[1]. For example, a client may want to hold onto a loss-making investment rather than feeling the pain associated with taking a loss. Or, more commonly, a client may want to buy into an investment after a period of market exuberance, when the cycle has most likely peaked.

Much of traditional finance theory is predicated on rational investor behaviour that advocates the notion that financial markets are efficient. The efficient market hypothesis argues that current stock prices reflect all existing available information, making them fairly valued as they are presently^[2]. It also suggests that people are free from emotion and make rational decisions based on fact. However, behavioural finance would suggest this is not the case; instead it asserts that financial decisions around investments, income, risk and debt are influenced by human emotions, biases and cognitive limitations of the mind in processing and responding to information.

Key aspects of behavioural conditioning and how it relates to investment decision making are as follows:

Loss aversion is a cognitive bias that describes why, for individuals, the pain of losing is psychologically twice as powerful as the pleasure of gaining. The loss felt from money, or any other valuable object, can feel worse than gaining that same thing^[3]. For a client experiencing loss aversion, it’s better not to lose $50 than it is to find $50.

Herd mentality is defined by the Oxford Dictionary as “the tendency for people’s behaviour or beliefs to conform to those of the group to which they belong.” Herd mentality manifests in finance when investors follow the crowd instead of their own analysis. It has a history of starting large, unfounded market rallies and sell-offs that are often based on a lack of fundamental support to justify either^[4].

Confirmation bias describes the tendency for individuals to seek out and prefer information that supports their own pre-existing beliefs. Consequently, the individual then tends to ignore any information that contradicts those beliefs. Confirmation bias is often unintentional but can still lead to poor decision-making in real-life contexts^[5].

Recency bias is considered to be a cognitive error identified in behavioural economics whereby the individual incorrectly believes that recent events will recur in the near future. This tendency is irrational, as it obscures the true or objective probabilities of events occurring, leading the individual to make poor decisions.

Cycle of investor emotions

It’s a good time to revisit the Cycle of Investor Emotions (figure one). Recent market gyrations would have most investors fearful and anxious (in the green zone) – there are enough days with markets finishing in positive territory to temporarily buoy emotions, followed by sideways or a downward trajectory. Although there has been a lot of talk about an inflation driven bear market, it’s not following the expected path.

While unadvised investors may make rash decisions in this environment, an adviser can manage their clients’ emotions by explaining market cycles and how they might feel at different points. By educating clients, advisers can provide this ‘behavioural coaching’ to best position clients to ride out the vagaries of financial markets^[6].

Investors typically start with optimism, which sits at the inflection point on the emotional upswing. At this point, investors expect things to go their way, or they expect to receive a return for the risk of investing. Investors go into the markets because they believe they will be able to grow their wealth through their investment choices.

When markets move in the direction the investor had hoped to see, they start to get excited about the possibility of even greater gains. This is when investors start hearing positive news stories in the media, coupled with tips from friends and colleagues, stories about how well their investments have done can mean investors are spurred on. This can be an attractive comfort zone because in such a scenario, investors are running with the herd.

When the momentum continues, investors can find the experience thrilling and begin to anticipate even higher returns – and sometimes start sharing their own tips!

As markets reach the top of the cycle, investors may experience euphoria.

At this point, the uneducated investor starts to believe that they made a smart move to invest when they did and believe that the good times will continue unchecked. In some cases, investors fool themselves into believing they can tolerate higher levels of risk and may begin to trade more frequently or invest in riskier asset classes.

The second phase of the cycle occurs when the market starts to turn. At first, investors watch anxiously to see if the downturn is just a blip. They may believe that things will improve shortly and therefore hang on to their investments. They often try to shield themselves psychologically from the bad news and move into denial.

As the markets continue to fall, denial gives way to fear. Investment values decline perhaps even to the point that investors begin to see losses. Bad news stories proliferate in the media and online. When market losses accelerate, real fear kicks in. Some investors may then turn defensive and switch out of riskier equities to more defensive equities or other asset classes such as bonds.

In the third phase of the cycle, the realities of a bear market come to the fore and an investor may become depressed and desperate.

Investors who missed their chance to take profits may try to get their portfolio back into the black by either selling their worst-performing investments or moving into securities that don’t fit their risk profile. When that doesn’t work, panic sets in.

At this point, some investors feel at the mercy of the market and capitulate, pulling out altogether, abandoning investments at precisely the wrong time.

Those who remain invested may become despondent and wonder whether they should ever have invested their hard-earned money in the markets. Interestingly, this is the part of the cycle identified as the point of maximum financial opportunity.

In the fourth phase of the cycle, investors may experience some scepticism when markets start to rise. They often have a sense of caution or worry, wondering if market growth will last.

Though investors are hopeful about continued market increases, they may be reluctant to invest money—even at a point when prices are still relatively low and opportunities are attractive.

Eventually investors come to realise the market is recovering. For those investors who let their emotions rule their investment decisions, the market cycle can begin all over again – unless of course they have good financial advice and understand the cyclicality of the market and the importance of staying the course in the asset allocation recommended by their adviser.

Inflation magnifies indecision

Consider the journey of four hypothetical investors who each invested $100 in January 2020 but reacted differently to the market downturn triggered by COVID-19 in March that year (figure two).

Fiona remained in the market and witnessed her $100 investment rise to $125 by June 2023 (blue line in the chart below).
Muhammad instead moved to cash in March 2020 after his $100 fell to $87, re-entering the market three months later. His ultimate investment was worth $112 in June 2023 (orange line in the chart below).
Paloma also moved to cash in March 2020 but waited until the following New Year to re-enter the market. Her investment was worth $101 in June this year (grey line in the chart below).
Craig was worse off still – he also bailed into cash in March 2020 and has never re-entered it. The $87 he initially moved to cash is now worth just $78 in real terms due to the impact of inflation.

As figure three illustrates, missing out on even a handful of the market’s best days can have a real impact on the amount of capital that someone can accumulate over time. This counterintuitive result occurs because markets, while unpredictable, have a history of rising over the long term^[7].

In fact, investors who remained invested in the S&P/ASX300 Total Return Index throughout the past 10 years built significantly more capital than those who missed just the 10 best days’ performance of the index in that period.

And those who missed the best 20 days wound up more than 50% worse off than if they had remained invested for the full decade.

Without the guidance of advisers, investors can fall into the trap of buying when markets are bullish and selling when sentiment turns bearish. There is real value in the ability of advisers to help clients maintain their long-term strategies in the face of unnerving volatility.

In another example, calculations show that regularly increasing or decreasing exposure to the US S&P500 Index might have cost investors as much as 3.39% in returns in the 20 years to June 2023.

Advisers who forge solid relationships with clients are best placed to convince them of the merits of maintaining the positions that underpin the financial strategies they formulate on their behalf.

Why advisers need to understand investor behaviour

There are several reasons an adviser and their clients will benefit from a good understanding of investor behaviour. These include:

Tailored recommendations: clients have different risk tolerances, financial goals and objectives and preferences. Understanding investor behaviour allows advisers to tailor recommendations to align with the client’s individual needs.
Risk Management: investor behaviour can be influenced by emotions such as fear, greed and overconfidence. By understanding these tendencies, advisers can help their clients to avoid impulsive or emotionally driven decisions that may lead to poor outcomes.
Long-term success: an understanding of investor behaviour helps advisers to guide their clients towards strategies that are more likely to lead to long-term success; this includes remaining committed to their investment plan through periods of market volatility.
Avoiding common pitfalls: being aware of common behavioural biases such as herd mentality, confirmation bias, loss aversion and recency bias allows an adviser to recognise when a client might be making decisions based on flawed thinking. They can then provide guidance to alleviate these biases.
Communication and trust: by understanding how clients perceive and react to financial information and market events is critical for effective communication. An adviser who truly understands investor behaviour and its drivers can explain complex concepts in a way that resonates with the client, building trust in the process.
Managing expectations: investor behaviour often includes unrealistic expectations about returns or the ability to time the market; an adviser can help set realistic expectations and educate clients.
Emotional support: investing can be an emotional journey, especially during times of market volatility. An adviser who understands investor behaviour and the cycle of investor emotions can provide emotional support and act as a steadying influence for the client. That way, rash decisions driven by exuberance, fear or panic can be avoided.

An adviser who understands investor behaviour is better equipped to provide holistic financial advice that considers not only the financial aspects of advice, but also the emotional and psychological dimensions of investing. This leads to a successful and truly valuable client-adviser relationship.