There are probably no more difficult conversations for advisers to have with clients right now than the one around potentially forgoing investment returns to take some risk off the table.
“I’ve got clients calling me and asking, ‘Is it time to go back in?’, said Cameron McAusland, a self-employed adviser licensed through MLC Advice and based in Sydney’s east. “What many people might not understand is there’s more risk around than ever. All they’re seeing is they’ve got another 12 months and missed out on another 4 or 5 per cent.”
McAusland’s clients aren’t all holding cash but, like many advisers, he’s been allocating his funds increasingly to more defensive strategies as local and global markets have continued to rise.
Now, at the latter stages of what’s become a decade long equity market bull run, clients are beginning to get a bit impatient and are questioning whether they’re missing out on returns.
Taking a more defensive approach to asset allocation at a time when financial markets continue to deliver strong returns requires not only an understanding of what’s driving returns in the current environment, but also insight into how people think, and what motivates them to make decisions in uncertain times, MLC head of investments Susan Gosling said.
Gosling and MLC portfolio manager Ben McCaw led a conversation about market risks and how behavioural biases can prevent people from thinking clearly and rationally about an uncertain future.
They were joined by financial planners McAusland and NAB’s Stuart McDonald, Schroders chief executive, Australia, Greg Cooper, Lonsec chief investment officer Lukasz de Pourbaix, and Allianz Retire+ head of consultants and research Cassandra Crowe at a roundtable hosted by Professional Planner and sponsored by MLC, titled “Investment Risk: Caught between perception and reality”.
“This is very clearly the most difficult investment environment I’ve seen in 30 years, and that’s including everything from the tech bubble to the GFC [global financial crisis],” Gosling said. “At other times in the cycle, there were still places to invest, there were places to hide. Before the GFC, for instance, nominal bonds were a great diversifier of equity risk. Today, there’s nowhere to hide.
“This manipulated environment is a consequence of the central bank response to the GFC. Not an environment of irrationality like the tech bubble, but something that has led investors to be induced to behaving in a particular way, to progressively move up the risk spectrum. This presents us with a real conundrum today, a stark trade-off between risk and return because diversifiers are so weak. It also means that to control risk you have to lag equities, or even traditional diversified funds, in terms of return.”
THE LONG RUN CONTINUES
It is in this unique environment that investors and professionals within advice and wealth management businesses are forced to overcome their own biases, which could otherwise lead them to take on more risk at the wrong time, MLC’s McCaw explained.
“People bring so many cognitive biases with them to investing, but one of the biggest cognitive biases is their own history,” McCaw said. “We live with that phrase, ‘time heals all wounds’ and we’re naturally hardwired to forget negative past experiences and focus on the positive. And when you have a cycle that goes on for so long, everyone forgets what it was like the last time you had a big downturn and you just become complacent.”
What’s exacerbating this complacency, McCaw said, is the low volatility in markets at the moment.
“There’s a great misconception that a lot of the market data we’re seeing is forward-looking, it’s not… The thing is you don’t often see volatility rise before markets crash, you see volatility rise after markets crash,” McCaw said. “Likewise with other relative value trades; central banks take [measurement of] inflation as a market survey of forward-looking expectations, but it’s not really, it’s a feedback of contemporary inflation or maybe just past inflation.
“So, the risk is, both in the data we’re looking at and in our own biases, we are construing what we’ve been through as what we’re going to [continue to go through],” McCaw said. “Superimpose that against the fact that there’s a whole lot of risk built up in the system underneath everything and you realise it’s potentially the worst type of situation for an investor or the most risky type of situation investors can find themselves in.”
At the coalface, financial planners are finding the conversations with clients need to get more nuanced, not only to address behavioural biases investors are dealing with but also to help clients come to terms with the unprecedented times we’re living through.
WHERE RUBBER HITS THE ROAD
One of McDonald’s clients, whom he calls “very conservative”, recently sold a unit for a $300,000 windfall and said, “Why don’t we take a punt on some of this and put it into something with more growth?”
“When I met [this client], most of her money was in term deposits. Basically, over a couple of years I moved it to what is essentially inflation-plus or moderate/ defensive investment options and for the last three or four years, she’s been getting about a 7 per cent return.
“I asked whether she’d choose to walk out of the room with $50,000, or flip a coin and walk out with $100,000 or nothing. She chose to walk out with $50,000.
“I explained to her you might get a 4 per cent return or a 9 per cent return and walk out the door, [in which case] you probably wouldn’t care either way. But if you get a negative-1 per cent return, which is yet another five per cent difference, you’d be fuming and gutted and angry at me. She kind of realised that it wasn’t a good time to be changing her risk profile or adding more money to a volatile market.”
GETTING THE STORY STRAIGHT
One thing clients have trouble understanding is what the investment and wealth management industry can and can’t do for clients, McCaw explained.
“I think the industry has done a bad job over the last 20 or 30 years of selling what we can and can’t do,” he said. “I mean, if you talk to retail investors I think most of them probably believe that we can time the market and that’s what we’re getting paid the big bucks to do, to see these things coming, but we’re just setting [ourselves up] to disappoint people at the wrong time.
“To get expectations right as an industry, we’ve got to be more honest about what we can and can’t do.” Schroders’ Cooper said: “I think what we’re poor at doing is communicating investing time horizons to end investors. I mean, what does ‘over the cycle’ actually mean? What does it mean to the average investor? That could be a very long period, it could also be a short time. Things have looked expensive for a long time, not a short time.”
Miscategorising risk and attributing it to incorrect asset classes is another area where the industry is falling down, which only serves to further confuse investors, Cooper continued.
“Something we have spoken about for some time is that most of the measures for risk people use at a multiasset-class level are not just misinformed, they’re actually directionally wrong in many cases,” he said. “I think there’s a pretty broad sectoral risk across the whole industry that seems to be very misunderstood.”
This so-called sectoral risk relates to the liquidity trade-offs investors are making to have exposure to certain asset classes.
“Looking at asset allocations of many of the MySuper funds, for instance, and how they’ve moved over the course of the last decade,” Cooper said.
“What’s regarded as a balanced fund today would have been regarded as a high-growth fund 10 years ago.”
These shifting asset allocation definitions are confusing investors, who are comparing growth-like returns with defensive funds.
“It’s making our jobs very difficult because people don’t want to miss out,” McAusland said. “Probably three or four years ago, we shifted our clients into more defensive allocations and our clients have missed out on some of that upside.”
What investors need to have explained is the fact there is no silver bullet in this environment when it comes to asset allocation, Lonsec’s de Pourbaix said.
“Some people will say ‘alternatives is the answer’,or bonds or equities,” he said. “All of those things can be very volatile. Even cash – there’s a risk holding cash because of inflation. Everyone is looking for that one thing to protect the portfolio but the real answer is it’s not one thing, it’s a combination of things.”
Product manufacturers need to be clear a product does what it says it will do and is in the correct category according to the underlying investments it owns, he said.
Working on bringing a new product to market in the retirement space means a lot of trying to understand and attempting to manage the expectation of end investors for Allianz’s Crowe. “We’ve done extensive market research in the lead up to bringing our first retirement income solution to market to effectively understand what the needs of Australian retirees are,” she said.
“One key observation is that existing investment offerings require retirees to choose and accept full market participation or to choose certainty, with lower returns and no market exposure. We believe the next generation of retirement solutions need to consider the ability to mix certainty with market participation.
“We believe that being clear with what you can deliver is always important, but particularly in today’s challenging investment environment.”
Existing risk profiling and advice tools might not be adequate to open the conversation about what is risk and confront behavioural biases, McDonald said.
“It is sort of over-simplified,” he commented.
“A lot of times, a standard seven-question risk profile where it pops out and says ‘you’re this type of investor’ doesn’t give the best results.”
McAusland added: “For me, it’s about understanding someone’s situation now, where they’ve been, where they’ve invested in the past. Then a little bit of education to kind of bring them back to what assets are doing now.”
Indeed, reflecting on history is a good way to anchor clients in the present and overcome automatic behavioural biases, Gosling said.
“We don’t reflect enough,” Gosling argued; reflecting on the past might help investors confront their
behavioural biases. It reminds us that returns vary a lot over time – investors can be lucky or unlucky depending on the starting point. While our innate bias is to expect positive returns to continue, the past reminds us that very strong returns can be followed by the reverse. While trying to forecast the future is not a reliable basis for investment decision making, we do know that looking forward from today return potential looks low and risk high. Limiting risk is essential to protecting lifestyle outcomes.
“This is an extraordinary investment environment,” she said. “None of us have seen this before. We don’t know how it’s going to play out or when the environment’s going to significantly change.
“All we can do is consider what future scenarios might play out and manage portfolios in a risk-aware way, maintaining risk control to protect the lifestyle outcome for investors.”