Delivering the free lunch – four ways fund managers can help investors avoid behavioural finance pitfalls

avoid behavioural finance pitfalls free lunchInvestor biases lead to poorly diversified portfolios and unwise market timing decisions when investors fail to avoid behavioural finance pitfalls.

This negatively impacts their long-term investment outcomes.

However investment managers who engage with direct retail investors have the opportunity to create value by showing how they can avoid these common mistakes.

Furthermore, when investors fully understand the value of:

  • Diversification
  • Investment fundamentals
  • Risk control
  • Long-term investing

they can profit at the expense of those who don’t – and have hence failed to properly optimise their portfolios.

“The beauty of diversification is that it’s about as close as you can get to a free lunch in investing.” – Barry Ritholtz

Through sharing valuable insight, managers can establish themselves as the direct retail investor’s candid friend. This leaves them well positioned to offer their investment solutions that help investors reach their financial goals.

 

Download our concise twenty-step guide to learn how an investment manager can establish a profitable and sustainable direct retail funds business through an engaged customer strategy.

 

Behavioural Finance

According to David Walker1: “Behavioural finance is the combination of behavioural and cognitive psychological theory with conventional economics and finance to explain why people make these irrational financial decisions.”

Our previous blog post reviews ten common ways in which investor biases lead to investment strategies going badly.

Fund managers can help direct retail investors avoid behavioural finance pitfalls when they share with them these four key facts of investment life:

 

1) Diversification is the only truly free lunch

Investment managers that take a global view are well positioned to question the home bias of many investors that negatively impacts their wealth.

According to FT.com2: “historical data show that, over time, global portfolios have superior returns per unit of volatility than their country-specific constituent indices.”

This is especially true for equity markets such as Australia that are dominated by one or two sectors, i.e. banking and resources.

Similarly the multi-asset investor can gain further diversification benefits by investing across less understood asset classes, including alternatives and a mix of growth and value stocks.

Fund managers who share their macro insight can demonstrate the value to investors of portfolio diversification.

The herd mentality and retail investors’ own internal instincts tend to steer funds to the current in-vogue growth stocks at the expense of those that represent value.

Fund managers can show how such an approach detracts from investment performance over the long term. It can show how diversifying across value stocks creates a more optimised portfolio with greater return per unit of volatility than one limited to growth stocks.

 

2) Investment fundamentals beat hunches

Investment managers are able to demonstrate the value of fundamental investing if they help investors establish a clear connection between investment process and investment outcomes.

According to Euroinvestor3: “A fundamental analysis is all about getting an understanding of a company, the health of its business and its future prospects. It includes reading and analyzing annual reports and financial statements to get an understanding of the company’s comparative advantages, competitors and its market environment.”   The same principles can be applied to sectors, markets and even asset classes.

A rigorous investment process is necessary in order to avoid behavioural finance pitfalls, namely biases that play no role in analysing the fundamentals of a security or market.

Clearly this is quite some commitment for the non-professional investor. However the alternative of hunch-driven investing carries enormous risks to the investor’s financial wellbeing.

Active fund managers also tend to do be more effective at managing the selling discipline. In carefully choosing reference points based upon fundamentals they minimise the risk of anchoring their thinking to entry price points.

Fund managers should also highlight the value of critical thinking that robustly challenges investment proposals. This tends to work more effectively within a group of professionals committed to process, reinforced by the use of a wide information set and open debate.

Managers are well positioned to share with retail investors how such an approach prevents a confirmation bias based upon pride and hubris.

 

3) Rigorous risk control helps avoid behavioural finance pitfalls

avoid behavioural finance pitfalls risk controlThe damage inflicted on portfolios by investors’ biases can be minimised if investing takes place within the constraints of rigorous risk control.

Investment managers can help investors avoid mistakes when they demonstrate to them the fungibility of money. Professionals understand the sameness of money regardless of its source or the way it is allocated. Unlike retail investors they generally avoid holding:

  • Over-priced stocks for sentimental reasons
  • Failed investments to avoid realising losses
  • A separately measured portfolio for high risk investments whose volatility does not impact core investment returns

One way that professional investors manage this is through a defined sales process that encompasses:

  • Price limits
  • Opportunity for rigorous peer review
  • Cultural willingness to challenge the status quo
  • Clear understanding of the role (and limits) of benchmarks in portfolio construction

 

4) Long-term investing delivers long-term investment objectives

Managers can help retail investors avoid behavioural finance pitfalls by demonstrating the importance of matching their investment strategy to their investment time horizon.

Investors are easily distracted by the “noise” of the immediate information flow. The ability to tune out irrelevant and short-term information is essential in order to stick to a long-term investment strategy.

Similarly, recent short-term performance has never been so highly visible to retail investors. Fund managers are well positioned to show how chasing recent trends (in sectors, style, funds or stocks) will detract from long-term performance.

The risk of being the General who is always ready to fight the last war is one that retail investors can avoid when they understand the importance of investing for the long-term.

avoid behavioural finance pitfalls long-term investing

Conclusions

Direct retail investors are particularly prone to making very basic investment mistakes.

This is because they are subject to irrational biases that leave them poorly equipped to avoid behavioural finance pitfalls.

These can cause major and permanent damage to their wealth.

Some retail investors are aware of these dangers, however history shows that most are not.

Investment managers who have developed an engaged audience of direct retail investors are well placed to help them from making these very human but costly errors.

This delivers the free lunches of diversification and a rigorous process at the expense of those investors who fail to establish an optimised portfolio.

Managers can do this by sharing their insight on the way that they oversee investments, to the interest of their audience of self-directed investors.

David Walker4 summarised the required approach as: “Confidence is preferred but humility is required”.

In developing such a relationship with a niche group of investors the manager can establish that:

  • Making unwise investment choices is avoidable
  • They are a candid friend willing to share their insight
  • Investing under a disciplined investment process within rigorous risk controls is much more likely to lead to investment goals being reached

This leaves the active fund manager (or ETF provider) well positioned to help the investor who decides that in light of all these challenges, a managed fund or ETF is the wiser choice for their wealth.




How do you think that fund managers can help direct retail investors avoid behavioural finance pitfalls?

 

We have created a concise twenty-step guide to how an investment manager can establish a profitable and sustainable direct retail funds business through an engaged customer strategy; please click here to download.

 

‘Free Delivery Represents With Our Compliments And Delivering’ image courtesy of Stuart Miles at FreeDigitalPhotos.net

‘Mechanical Business Men And Women Walk Straight Into The Abyss’ image courtesy of Sira Anamwong at FreeDigitalPhotos.net

‘Winding Road’ image courtesy of supakitmod at FreeDigitalPhotos.net

 

1 Walker, D, 11 September 2015, Clime, “Five Common Investment Biases and How to Avoid them”, http://www.clime.com.au/latest-news/five-common-investing-biases-and-how-to-avoid-them/

2 FT.com, 8 February 2015, http://www.ft.com/cms/s/0/9656990e-abac-11e4-8070-00144feab7de.html#axzz46LMvzkZs

3 Euroinvestor.com, 15 February 2012, http://www.euroinvestor.com/ei-news/2012/02/12/stock-school-5-important-elements-in-fundamental-analysis/15694

4 Walker, D, 11 September 2015, Clime, “Five Common Investment Biases and How to Avoid them”, http://www.clime.com.au/latest-news/five-common-investing-biases-and-how-to-avoid-them/

 

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