These haven’t been times for investors who cannot discipline their emotions. They have needed, perhaps, a friendly hand on the shoulder to avoid big mistakes. That’s where behavioral finance, and advisors who understand it, come in.
Months of market gyrations, for example the case of the US computer entertainment retailer GameStop and bitcoin, have tested investors’ nerves. And these stories underscore how the rise of what is called behavioural finance is no surprise. In fact, the tumult suggests that the discipline has much further to go in guiding clients' investment decisions.
A year ago, as the pandemic struck and countries around the world went into lockdown, equity markets crashed by about 30 per cent, but then recovered relatively fast amid massive central money printing, aka quantitative easing. Toward the end of 2020, and into this year, cryptocurrency bitcoin surged, rising from just above $29,000 at the end of December 2020, to above $57,000 in February 2021. And early in the New Year, users of social media platforms such as Reddit combined to attack short-selling hedge funds that had been negative on GameStop and several other firms. The dramatic price action forced a large hedge fund to be bailed out, as well prompting noises from regulators.
Adding in the angst about the global pandemic and the ups and downs in mood over the rollout speed of COVID-19 vaccines, it is clear that these haven’t been times for investors who cannot discipline their emotions. They have needed, perhaps, a friendly hand on the shoulder to avoid big mistakes. That’s where behavioral finance, and advisors who understand it, come in.
“When you think of behavioral finance and mistakes that people make, everyone talks about selling at the bottom but actually problems may come when there are high valuations. But no-one wants to hear about it!” Phil Toews, chief executive at Toews Asset Management in New York, overseeing a total of $2 billion of client assets, told this publication. “We have concluded that if we did not figure out investors’ behavior, investors would not realise the potential benefits.”
“The real heavy lifting that we do is when bad things happen with an investor and they get frustrated and the approaches they have been in don’t work,” Toews continued.
In some ways, the extraordinary fact of how scores of countries have locked down citizens, shutting business and erasing jobs to curb the pandemic, amounts to a massive behavioral experiment. And it has galvanized the subject, he said.
“Before COVID-19 there were lots of behavioral experts speaking but it was not really changing what people did.”
We want it all, and soon
One matter that behavioral finance practitioners need to understand is that in an age of social media, modern technology and a 24/7 news cycle, people, such as younger adults, hold what might appear to be a short-term mindset, Frédérique Carrier, head of investment strategy at RBC Wealth Management International, said. (Her remit includes the British Isles and Asia.)
“This is a generation of people who want to do things very quickly. Millennials are now moving into the investment space and we are going to see this more and more.” While the GameStop story plays to a “little guy vs Wall Street” narrative, that story might not last very long, she continued.
This news service asked Carrier if background macroeconomic conditions – such as a decade-long bull market from 2009, and central bank quantitative easing – had created a false sense of security among investors, encouraging the notion that markets are a one-way bet. She agreed: “People have become confident that the market can only go one way.”
Give advisors the tools
Toews argues that too few US advisors grasp behavioural finance insights and apply them to managing client portfolios.
“We were seeing advisors were not doing much to alter investors’ behavior,” he said.
Toews Asset Management has developed a communications approach for advisors to help clients understand what might appear to be counter-intuitive solutions, he continued.
“We think traditional ideas of building portfolios are not attuned to this understanding of investors’ behavior. A lot of work [in this area of finance] has yet to be done,” Toews said.
Recent experience still holds sway on clients’ and advisors’ minds, and that can be a problem, he said. “The entire [investment] industry has recency bias,” he said.
“Recency bias” is a term describing the cognitive bias that favors recent events over historic ones. Investors can be led into a false sense that what happened in the past few years will hold sway in the future.
He described how to visualize markets, often using examples such as the impact of the Great Depression, to help clients imagine the future of their investments.
Toews said that clients and advisors need to address goals such as avoiding big losses, achieving above-inflation growth, and maintaining gains. “That is different from maximizing gains for a given level of risk,” he said, referring to the standard approach that a lot of advisors take.
A great deal of conventional approaches (a certain chunk in equities, and the rest in bonds) assume that markets are broadly efficient. But markets can misprice risk/earnings and reach a level that is extreme.
Toews was asked if central bank quantitative easing had led investors into irrational confidence in continued stock market gains. Toews accepted that this process has contributed to people not learning more from what has happened with markets in the past.
“We now have tippy-top valuations and more people want to get into the market,” he added.