Behavioural bias is one of the main ways advisors can help investors retain value in their portfolios.
My name is Andrew Surrey, senior business development manager at Vanguard.
We are all subject to behavioural biases. Most of the time, these are positive. They are nature’s way to enable us to operate effectively. They are short-cuts to making good decisions without a long, complex process of rational analysis.
But do our natural behavioural impulses work for investment?
Let’s look at an example.
This is what is known as an emotional bias.
Loss aversion is almost always a good thing. It’s easy to understand why evolution would favour loss aversion. From an economic perspective however, there is no reason to weight gains and losses so differently.
The curve represents the joy we feel from winning. As you can see, the gradient flattens quickly. We get nearly as much pleasure from winning ten thousand pounds as from winning twenty thousand pounds.
Down here, by contrast, we see the response to loss. It is much steeper, it is much deeper, and it doesn’t level off. It just gets worse and worse. Losing twenty thousand pounds feels a lot worse than losing ten thousand.
We evolved to survive by maximising opportunities whilst minimising threats.
But how can this affect investment? Loss can lead to strong emotions, primarily – guilt, regret, anger – which in turn can lead to impulsive, poorly reasoned decisions – decisions that may well lead to further loss.
Let’s look at an example.
In 2008, financial markets were in a state of collapse. The equity markets were in collapse. Lehman Brothers, one of the great global investment banks, was in bankruptcy. In the UK, Lloyds and RBS needed huge public bail-outs.
As we can see here, Index returns on a portfolio split between UK bonds and equities lost over 20% between August 2007 and February 2009.
From an emotional point of view it may have felt like a very good time to leave the market.
But of course it wasn’t. It was a very bad time to leave the market because within a few weeks the market reached a bottom and rallied strongly…
So for those who left the market, and fled to cash, their returns look like this…
And for investors who switched to fixed income…
A financial adviser who counselled a client to stay in the market, to not succumb to an emotional response, to not succumb to a behavioural bias toward loss aversion, but to stick to their goals – you can see immediately the value that adviser added to the client portfolio.
Between the trough of the market in February 2009 and the end of May 2015, index returns for a 50/50 UK bond and equity fund were 90%, for a bond fund, 52% and for cash 4.5%.
Thank you for watching.
If you would like a workshop on how financial advisers can add value through behavioural coaching, please call 0800 917 5508 or speak to your Vanguard representative.
Past performance is not an indicator of future results.
Source: Factset, Vanguard, to 31 May 2015. Equities are represented by the FTSE All Share Index; bonds are represented by the Barclays Sterling Aggregate Index; cash is represented by 3-month LIBOR. Performance is shown as total returns in sterling.