People make mistakes. It’s called being human.
Few would be surprised to learn that one in five Australian motorists have been involved in at least one car accident in the last five years, based on Roy Morgan Research, and there were 48,000 divorces in Australia in 2014, according to McCrindle Research.
Still people continue to get married and drive cars.
Yet when it comes to investing, people are genuinely shocked and dismayed when they pay too much, pick a dud or simply hold on for too long.
The study of systematic human behaviour, known as behavioural science, provides insight into how and why people think, act and react a certain way in different circumstances.
Behavioural finance is a relatively new field which combines behavioural science and conventional finance and economics to help explain why people are prone to making irrational financial decisions.
Every investor knows the plan is to buy low and sell high but many do the opposite. And it’s not only the inexperienced and unsophisticated. Professional fund managers and advisers are guilty too.
According to behavioural finance, there’s a psycho-physiological explanation why people rush into an investment at the height of the market and sell at the bottom. Effectively, investors are wired to follow the herd. Many have unrealistic return expectations and overestimate their ability to make smart financial decisions. They want a quick win, and if they feel like they’re missing out, they’re more likely to punt on speculative investments or fall for a scam.
This kind of emotional behaviour is akin to the social anxiety FOMO or “fear of missing out”. The behavioural finance version can clearly be seen among young couples who gear up and pay too much for property because they’re desperate to get into the market. At the other end of the spectrum are retirees and pre-retirees who suddenly realise they can’t afford a comfortable retirement and get embroiled in scams.
Investors who suffer from FOMO are extremely vulnerable and prone to making mistakes.
Armed with all this knowledge, advisers can incorporate behavioural finance principles into their business and advice processes to educate clients about behavioural biases, manage their expectations, encourage them to take a long-term holistic view and prevent financially destructive behaviour, ultimately leading to better outcomes and higher client satisfaction.
For example, herd mentality or mob mentality – the reason why many investors, influenced by their peers and the market, flock into stocks for no logical reason and often with disastrous consequences – can be overcome with a little education and basic safeguards.
A key premise of behavioural finance is that a disciplined rules-based approach delivers better outcomes because from the outset it establishes guidelines and parameters that support positive behaviour and stop people from making rash, knee-jerk decisions on the fly.
The case for strategic advice
It’s not dissimilar to the case for strategic advice, which is ultimately about helping people do more with their money and achieve their long-term goals by making smart decisions, managing key risks, and sticking to a robust strategy.
But that’s easier said than done.
It’s hard to stay calm and disciplined during a crisis, which is why a formal, structured investment approach, like a managed discretionary account program, can help reinforce strategic advice and keep investors (and advisers) on track.
With a managed account structure, the managed account provider, which could be a licensee, adviser or investment manager, together with the client and managed account operator (see note) collectively develop, and agree on, an investment program that meets the client’s personal needs, preferences, objectives, beliefs and risk tolerance.
A managed account program will typically set out a portfolio’s general holdings, strategic asset allocation ranges, maximum single stock exposure and level of risk.
The adviser interface with the client ensures a much more considered approach to portfolio management than with traditional managed funds which must transact based on inflows.
Advisers have the authority and autonomy to act with discretion within the set parameters, and clients know their portfolio is being professionally managed according to a clear, predetermined investment framework.
Each party recognises that the parameters and guidelines made purposefully and rationally under normal conditions will continue to be relevant and hold true when times get tough.
Even if a client (or adviser) is tempted to impulsively buy or sell, they can’t deviate from the original plan.
A managed account program brings structure and order to portfolio management, which ultimately delivers greater financial certainty to investors and advisers.
By incorporating behavioural finance principles into portfolio construction and portfolio management processes, advisers can help their clients avoid ill-thought-out, reactive decisions and stay on course towards achieving their goals.
Note: Moran Howlett is a client of managedaccounts.com.au