While an asset allocation may be mathematically optimal, it does not solve the fundamental problem of behaviour, particularly that of endless panic, according to Dr Stephen Wendel, head of behavioural science at Morningstar.
Speaking last week at a CFA seminar on managing the psychology of risk, Wendel said asset allocation has nothing to do with how people respond in times of stress.
“Instead, we have to address the underlying anxiety,” he said.
“We have to address that problem. How can we help members get the mathematically optimal portfolio and actually keep them in that portfolio? That’s the problem; actually sticking to it over time, especially in downward volatility, as that is where we see the greatest damages.”
For example, those who left the market in the 2008 downturn and stayed out for just six months lost out on the great upswing that happened afterwards.
“The problem isn’t the investment, it’s the information about it,” Wendel said.
“Research has shown that traders who frequently look at price updates are less aggressive in their investments. The action of getting new information about what the market is doing affects trading behaviour, which should scare you.”
Contrarian investors may have it right
This behavioural bias can be used to a planner’s advantage. Communicating to clients that we are all subject to overconfidence and confirmation bias has been surprisingly successful in stopping them from making poor decisions, Wendel said.
“Another approach is to short circuit that emotion by giving people a different story, a different way of interpreting the facts of what’s going on. Contrarian investors have done this extraordinarily well.”
The contrarian story is one of seeing the markets go crazy and using that as a signal to move in the opposite direction.
“Contrarian investors arm themselves for that emotional onslaught with a different emotion. We see this with a technique called anxiety reappraisal, which was initially studied with public speaking.”
The advice for those anxious about public speakers was for them to tell themselves they were excited, as anxiety and excitement are chemically quite similar in the bodies.
Wendel argued that simple intervention is quite powerful because telling somebody, “Just calm down, you idiot,” doesn’t help, because there are hormones rushing through the body.
“We can’t stop those hormones, but what we can do is say ‘I’m excited, I’m gonna use this’.”
