What makes some investors revel in danger and others flee at the first sign of market volatility?
7:56AM BST 19 Aug 2011
7 CommentsEvolution has programmed us to flee from danger. But the same instinct that protected early human from the sabre-toothed tiger makes for an unsuccessful investor. As global markets have fluctuated wildly, investors have been indiscriminately cashing in their investments, panic selling as times get tough.
A tenth of the fund supermarket Fidelity FundsNetwork's customers have switched their investments into less risky assets as a result of the eurozone worries, with low-risk bond funds the preferred option over equity or equity-income funds.
But if those investors kept their composure and did nothing, they would have made money as banking stocks pushed the FTSE 100 up to close last Friday on 5,320, compared to 5,247 the previous week.
But what makes some people flee to cash deposits as markets crash and others gleefully seek out opportunities among the ruin? While many of us would prefer to consider ourselves spontaneous risk-takers, when it comes to the crunch, most investors value capital preservation over high-risk, high-income investments.
"Everyone wants minimum risk and maximum return, but it is rarely possible to do both," said Neil Pedley of Vestra Wealth.
Wealth managers have the complicated task of gauging a client's risk appetite to allocate their cash correctly. Rather than take the client's word for it, wealth managers at Barclays Wealth employ personality profiling to gauge investment attitudes.
"It can be difficult for investors to be honest with themselves," said Greg Davies, who is head of behavioural finance at Barclays Wealth. "Some people like to think of themselves as composed risk-takers, but if you try to invest in a way that does not respect your natural 'type', you make decisions you are not comfortable with and you will lose money."
There are two parts of our brain that govern decision making.
1. The first is rational, logical and more suited to decision making based on long-term goals.
2. The second controls emotional decision making – the fight-or-flight reflex.
1. The first is rational, logical and more suited to decision making based on long-term goals.
2. The second controls emotional decision making – the fight-or-flight reflex.
In times of stress or perceived danger, humans default to the emotional brain and seek instant gratification, rather than considering long-term success. Though this "action bias" may have been a successful tactic when early human was faced with a predator, it does not help investors make money.
"When we pull our money out of markets during a crash, we get instant emotional gratification. We are happy because we have removed ourselves from the perceived danger – the risk of losing more money. However, this short-term thinking is bad for long-term goals," said Mr Davies.
As well as asking clients about their investment goals, Barclays constructs client portfolios based on the results from the personality profiling, which assesses composure in the face of risk.
The idea is that two clients could have the same amount of money to invest and the same long-term investment goals, but if one has a high level of composure and the other a low level of composure, their investments should be different. The client with the low composure is more likely to act rashly when he sees his investments fluctuate in value, so his portfolio is hedged with slower growth but low-volatility assets.
By constructing a portfolio in this way, Barclays lessens the chances of clients falling for pack mentality – buying at the highest price and selling at the lowest.
Wealth manager HFM Columbus also uses psychometric profiling to help determine clients' attitudes to investment risk, as well as the ways to best service clients, for example, are they likely to read fund literature, or would they prefer a short summary?
The test assesses five major personality traits: openness, conscientiousness, extroversion, agreeableness and emotional stability. "We are focusing principally on the 'conscientiousness' variant to ascertain how much or how little the client wishes to engage in the advice process and to ensure that we deliver the correct amount and type of information in order for them to make a decision," said director Marcus Carlton.
"We anticipate that the client's degree of conscientiousness will inform us if they are rash decision makers or if they make more studied decisions, and the profiler will also look at emotional stability in order to analyse likely reaction to unexpected outcomes – for example severe market volatility – so that we can protect clients and manage their expectations better."
You do not need a psychometric test to take advantage of this psychology. Mr Davies said investors should exercise self-knowledge and put in place a set of rules for investing.
"Most of us can help break our emotional investing habits by setting a framework in place in times of calm to be prepared for times of turbulence. You can bet those investors who are taking advantage of value stocks now will have planned their response to these situations. They will be informed and have engaged with markets for a while," said Mr Davies.