Are your clients wired for failure?

More and more experts in the relatively new field of behavioural finance are beginning to think that human beings are somehow ‘wired’ to be more susceptible to behaviour that produces less-than-great results.

For example, as investors, we are great at predicting the past. Cash flows into equity funds are a good illustration of how we condition our behaviour based on recent happenings.

Looking at cash flow statistics over a period of 20 years in graph 1 (see Money Management Magazine April 5, 2007 page 48), we can see that money tends to flow into equity funds in the 12 months after shares have performed well, and flows into bond funds in the 12 months after stocks have done poorly.

Yet, while money followed past performance, future performance didn’t necessarily follow the money.

When we analyse actual market behaviour for the same period, we find that there is virtually no correlation to investors’ purchasing patterns.

In fact, in the period after extensive cash flows had gone to share funds, bond funds actually outperformed, and vice versa.

Investors turn out to be great at predicting the past, but we’re not terribly good at guessing what’s going to happen in the future.

Analysing annual market returns of the S&P 500 Index in the US, Dalbar have determined in graph 2 (see Money Management Magazine April 5, 2007 page 48) that the average equity investor playing the stock market eroded around 8 per cent from the broader market returns over a 20 year period! This occurs because investors make wrong decisions 75 per cent of the time during downward trending markets.

Note that this time period represents the greatest bull market in history, but the average share market investor, through poor decision making, achieved returns below those from government bonds.

Why do investors chase returns?

There are a number of reasons why we do this, and first and foremost it comes down to emotions.

Humans are emotional about money. So, in many cases, sound investment principles tell investors to do the very thing they can’t emotionally do.

Selling a winner, for example, to rebalance a portfolio is counter to what people emotionally want to do. Investors rely on their emotions when emotions should play no role in investing.

Emotions tend to turn rational investors into irrational investors, and developed, diversified long-term financial plans are placed in jeopardy when investors are confronted by extraordinary events. And, many investors lack the assistance of a professional financial adviser to help set them on track to achieve their financial goals and then ensure they stay there over the long term.

If we are to believe the data results, then investors need an adviser to ensure they achieve their objectives.

The adviser’s role here is crucial to the investor’s financial success. Advisers need to explain the benefits of discipline to clients, and develop a strategy to ensure the implementation of a disciplined and sophisticated approach to investing.

Here are some points advisers should consider when setting a client’s investment strategy.

1. Normal isn’t normal at all

While we would expect investors to be more comfortable and behave rationally during normal market periods, it’s important to realise that we rarely see ‘normal’ market conditions.

On average, Australian shares have returned 14 per cent per annum since 1950 (Australian share market returns 1950 to 2005, Russell Investment Group).

However, most of the time equity markets have been either up significantly or down significantly. Individual year equity market returns have rarely been close to their average return.

In fact:

~ 29 times out of 56, the market returns were over 15 per cent, that’s 52 per cent of the time the market was up significantly;

~ 16 years out of 56, the market lost money, that’s almost 30 per cent of the time the market was in the red; and

~ only 11 times out of 56 did the market return fall within a range of 0 to +15 per cent, that’s just 20 per cent of the time that the market was even close to what we may normally expect.

Over the past 20 years we have been experiencing a golden age where not only has it been a bull market for equities, it has also been a bull market for fixed interest. Equities have returned 14 per cent per annum and bonds have returned 11 per cent. These are exceptional return figures.

If we strip out inflation, bonds have generated a real return of 7.2 per cent over the past 20 years.

We know that an annual compound return of 7 per cent will double the value of your clients’ portfolio every 10 years. This means that a bond portfolio taken out in 1985 — a very low risk investment — would have quadrupled its value in real terms over the past 20 years.

Your clients are never making decisions in ‘normal’ market conditions: markets are either up or down. And as returns are likely to be lower in the future, discipline is set to become even more important.

2. Shares versus bonds

One of the key things to remember is that you have got to get the big decisions right — and equities versus fixed income is the biggest one.

Other areas may improve portfolios, such as emerging markets and global property, but your equities versus bonds decision is going to be the most important.

It’s important to note that, not every year, but over time shares beat bonds. Over past 20-year periods, shares have always outperformed bonds, but you need to be fully invested each and every trading day to achieve this return.

The probabilities drop away quickly if you are not fully invested every trading day (see graph 3 Money Management Magazine April 5, 2007 page 48). This is where discipline is essential.

3. The evolution of diversification

In the past, client portfolios were not as well diversified as they are today. The advice used to be to divide a portfolio into thirds: shares, cash and property. This was often the rule of thumb and was largely because of two main reasons:

~ the lack of products available to achieve market diversification; and

~ the lack of computer programs and technology to model optimal portfolios.

Fortunately, times have changed, strategies have evolved over the past 20 years, and today the result is better diversified portfolios.

Today’s portfolios have more asset classes and multi-managers tend to dominate, as they can easily package well diversified portfolios. This provides diversification at the asset class, manager and style levels in a cost effective way.

The biggest decision in a portfolio is how much equity risk to take. Once this decision is made, the next step is to make intelligent use of a risk budget (that is, how much risk you take) through gaining exposure to a range of strategies and the latest innovations.

Strategies for investors

So, with all of this in mind, here are some simple strategies you may find useful for your superannuation clients:

~ disciplined investor behaviour;

~ stay invested to achieve at least the market return;

~ optimise asset allocation according to long-term strategy;

~ rebalance consistently (be mindful of transaction costs);

~ enhance returns using risk intelligently;

~ look beyond traditional investment vehicles where appropriate; and

~ seek innovative approaches to capturing excess returns.

The temptation to fall victim to our natural instinct can be resisted by developing and committing to a well-defined, long-term investment strategy. This is the best way to protect your clients from their emotions and to set them on track for a comfortable retirement.

Chris Corneil is managing director, Retail Investor Services at Russell Investment Group .