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Blue Chip Journal - March 2019 edition

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INVESTMENT SOLUTIONS

INVESTMENT SOLUTIONS Emotional rescue Stopping your clients from sabotaging their own financial futures Carl Richards is a very wise man. As he has often pointed out1 a successful investment outcome is as much about successful investing behaviour as it is about owning successful investments. Financial advisors must help their clients make the right decisions about how to save part of their current income to provide for their future consumption needs. This leads to advisors and clients spending a lot of time trying to answer: “Who is the best investment manager in South Africa?” or “Which is the best investment fund?” What is not 38 www.bluechipjournal.co.za

INVESTMENT SOLUTIONS always appreciated is that good investing behaviour is probably even more important than these questions. The most important principle of good investing is to accept that the future is unknown and make any investment decisions accordingly. This has several important implications: firstly, once the appropriate investment solution has been identified for the goal in mind, always stay invested; secondly, any portfolio must be diversified effectively. Effective diversification means holding multiple asset classes, and then, within each asset class (where possible) holding more than one investment strategy (or style), and then finally, more than one asset in each of the strategies. Thirdly, a rebalancing strategy that is consistently implemented is required. The final rule of good investing behaviour is make sure there are enough liquid assets to meet any short-term cash flow needs. Having to sell illiquid assets (eg direct property) either at what could be a poor market for them, or where a major discount is required to turn them into cash in a hurry, can negatively affect an otherwise successful investment portfolio. The real problem advisors face is as simple as these rules may seem to be, their clients generally don’t follow them. This is because investors are human beings – they have emotions and decisionmaking biases that work against them in terms of achieving good investment outcomes. These emotions include overconfidence, fear, greed and regret, while the biases include (among others) loss aversion, mental accounting, herding and anchoring. This combination of emotions leads to several very common destructive patterns of investing behavior, namely investors commonly stay in safe but low-returning investments (for example cash) for too long, as the threat of losing money is too painful (particularly if this has happened in the recent past). However, when individual asset classes (for example equities), investment strategies (for example value) or individual instruments (for example Naspers) perform well investors eventually decide to buy them. Unfortunately, this is usually after a good portion of this outperformance has already been achieved. When this pattern reverts itself (as it always does), the investors tend to cling to their investments for far longer than they should. This is due to the emotional attachment to their past decisions – nobody likes admitting they’re wrong, after all. Moreover, crystallising losses is very painful, so it’s easier to hold on in the hope that matters will improve in the future. As people tend to make investment decisions focused on their anxietyadjusted returns (instead of their riskadjusted returns), the returns they experience are very different to those they need to get. A recent study by Dirk Louw of the North West University2 showed that South African investors typically have a drag of 1% annualised over the investment horizon caused by the poor investing behaviour discussed above. This research shows that, during the 2008/2009 Global Financial Crisis, more than half of the investors in the sample acted in a way that destroyed value. While anybody can (in principle) follow the rules of good investing, professionally managed multi-asset class portfolios would be a good solution for most advisors and their clients. However, there are two different types of portfolios in this space, namely traditional balanced portfolios, managed on a peer-relative basis, and outcome-based portfolios, constructed to deliver on the investor’s specific goals. While seemingly similar, there are some important differences between these two – particularly when taking investors’ potential for self-destructive behaviour into account. Firstly, from a philosophical perspective, the outcome-based portfolios tend to have a far stronger focus on managing the probability and extent of short-term losses than their balanced competitors. Secondly, the probability of achieving the outcomes of the investor is different for these portfolios. Recent research3 compared the probability of achieving a real return target, using the average asset allocation of the balanced portfolio population compared to portfolios managed explicitly on an outcome-based Professor Evan Gilbert, Momentum Investments and University of Stellenbosch Business School philosophy. The outcome-based portfolios were between 14% and 17% more likely to achieve the return target, depending on the return target. In addition, their drawdowns (loss of capital over short-term periods) were lower. Financial advisors’ primary responsibility is to manage their clients’ emotions through turbulent times and the negative behaviour that often follows. Appropriate investment solutions are those that minimise the potential for bad investment behaviour. This means minimising the effect of short-term market turbulence, while still maximising the probability of achieving the longerterm investment goal. Outcome-based multi-asset class portfolios are explicitly designed with these in mind and the evidence suggests they are more likely to deliver satisfactory outcomes for advisers and their clients. Outcome-based investing is about helping investors realise their long-term goals – helping them turn their bucket lists into checked lists. No matter what the markets do or how trends shift, investors are able to achieve their best possible outcomes. ■ 1. See, for example: https://behaviorgap.com/blogs/articles/ outperform-99-of-your-neighbors 2. See https://orcid.org/0000-0002-4761-0485 3. Available from the author. www.bluechipjournal.co.za 39

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