Why most clients need an advisor and why most advisors are not the solution

I have been in Dubai since the last century (which only seems like yesterday). It is amazing how much has changed, but one thing that has not changed is our ability to control our emotions when investing.

I have been a traditionalist when it comes to investing and I am a firm believer in separating protection from investing, this is mainly to do with cost. I do understand that there is a need for future tax planning, but this has to be tied to financial planning.

Unfortunately, many of the tax planners lack the experience and discipline when it comes to financial planning.

The main difficulty is “Individual Investor Behaviour” and unfortunately these traits are often replicated by the Investment Advisor.

Investment Management is a skill that is hard to learn, requires a lot of experience and it is important to remove the emotional part of the decision-making process.

A Financial Advisor often tailors products to clients that they believe the client want, as opposed to dressing up the investment they need into something they want.

Let me explain,

Much of economics forecasting and investment advice is based on the notion that human beings are rational beings who attempt to maximise wealth creation while minimising risk.

However, there is empirical evidence that the investing behaviour of individual investors, results in returns that are way below the benchmark (market returns) They tend to hold losing investments and sell profitable investments.

One prime example is the very expensive and typical UAE offered savings plans. The redemption value is often a fraction of the money paid in, however investors who need to raise cash, would rather sell a good performing investment than liquidate this poor performing investment i.e. showing “regret” about the investment decision but unwilling to do anything about it. This is one of the standard behaviour traits of most individual investors.

They are also heavily influenced by which country they either come from or intend to retire to and as a result they end up having portfolios that is very far from being diversified They end up creating unnecessarily concentration by holding a lot of assets or investments in that country, this by nature has higher risk.

The investor is also often influenced by what they read online and hear on the news. As a result, they tend to sell when fear is persuasive and buy when news is positive. This is emotional investing, and empirical evidence shows it results in underperformance.

Look at this chart

graph

Source Hargreaves Landsdown

Each event may have influenced your buying and selling decision, but look at how the market has performed.

Investors are heavily influenced into buying investments that have gone up in the past thus reinforcing the buying decision while avoiding investments that has lost in the past. This results in having undiversified portfolios.

If the advisor carefully assessed the risk and return of all possible investment opportunities, create a portfolio that would suit the clients risk aversion and not what the client thinks is low risk. The most likely result with the former is having a client’s expectations dashed.

Let’s look at the influencers when we make our investing decisions.

a. The investors performance.

It is a well-known fact that men tend to underperform women, this is due to men being prone to more over confidence than women. Which seems to contradict the concept of investing being a male “thing” a bit like the man has to do the BBQ.

This overconfidence often results in men trading more often than women, when you look at the buying/selling costs involved then you have to generate an even bigger return before you can start to earn as much or more than the market. This excessive trading often leads to poor returns.  There is also the added factor that the underlying asset purchased may be the wrong asset.

It makes you question why? Especially when evidence shows that passive investing generates better returns. It was interesting to note that in a study by the Wall Street Journal, Funds that had the lowest total expense ratio tended to be three times more likely to beat the market than the expensive Funds (check your current invesment Funds for the TER Total Expense Ratio and not the AMC of the Funds)

Let’s look at investor behaviour

b. Overconfidence, i.e. a belief that one knows more than the market and more than the median person.

Example, when asked about driving skills relative to other drivers, most believe themselves to be above average, it is this over estimation that leads to investment mistakes. My daughter continually tells me how well she is doing in school and what high marks she has. However, when I check the facts I often find that she is just average compared to her peers. This overconfidence often results in people making bigger bets based upon their own judgement.

Hence you have men changing investments more often than women and they tend to end up with lower performance than women.

c. I want to be a star.

How often have I seen people wanting to show other people how smart they are, I have also seen this often when some advisors recommend unsuitable investments. Today it could be Bitcoin without fully understanding the risks, or chasing the new Google’s of the world because of past performance. i.e., looking for lottery wins instead of diversifying a portfolio and looking for a steady but more consistent increase in wealth.

d. Familiarity,

Overweight in an asset class or country of which they are familiar (home bias).

It makes them feel safe, but they then become exposed to increased volatility. This is more pronounced with investors that lack investment experience.

They avoid investing in foreign stocks even if these foreign stocks have a lower correlation to the domestic market.  Investing in foreign stocks can reduce risk and give better returns.

e. Why do people like to sell the winners and hold onto the losers?

Why do we continually repeat our mistakes? This has more to do with pleasant experiences vs negative experiences, we tend to go out and repeat the purchase of our last winners than purchase the losers. In fact, the greater the past return the greater our desire to trade again in that investment.

The Wall Street Journal in the same analysis of 5 star Mutual Funds all the way back to 2003 discovered that only 12% of these Funds kept those stars longer than five years and on average they became a 3 star fund in 10 years, in fact 10% of these Funds had dropped to only 1 star.

It would appear that we should not be influenced by previous winners but to look at each investment in its own right.

If investors do not have to feel responsible for buying and selling decisions then by nature they do not start selling winners and keeping losers, hence one of the attractions for discretionary management as well other hands off investing.

f. What is the next hot sector?

People tend to have a limited attention span when it comes to investing.

They face a huge problem when it comes to choosing what investments to purchase, they are unable to do systematic intensive research or even have the knowledge to be able to do the research, and as such tend to purchase what is immediately in front of them. i.e. buying today’s stock in the news or in the press.

g. Result is a lack of diversification.

If you are looking to reduce unnecessary risk and still achieve the correct investment outcome. You should not be in one asset class. No matter if it is the best performing asset class, you will always have systemic risk. If the market goes down, then no matter how good your investment is, it will also go down.

Evidence shows that real investors often end up holding under diversified portfolios and carry a lot of concentrated risk, despite the evidence showing the opposite is required to create wealth.

Smaller portfolios are also an ideal example, perceived to be too small to diversify, they concentrate the investments into a narrow asset class. However, that need not be the case. ETF’s are extremely efficient at diversifying and very inexpensive.

One of the biggest drags on performance is costs, if someone is paying on average 4.5% p.a. in fees as is often the case with insurance backed investment/savings account. Then how will they achieve anywhere near what is –

a. required to generate positive inflation adjusted returns

and

b. greater returns than passive investors?

This happens when you mix cost and emotional decision making.

Let’s be contrarians?

Investors and advisors tend to buy using a rear-view mirror instead of buying with a forward view.  i.e. they buy with a hope that they believe “what will happen” (tendency bias) assuming that the past is an indication of the future. They then sell after an event has actually happened (capitulation) or they sell to lock in a gain and hope to repeat this on the next trade and not because they believe that the past winner is a future loser.

If you buy the worst performing asset class at the end of every year, you will most likely outperform the best asset class of that last year.

Conclusion

Statistical performance returns shown are purely academic, in the real world it is different. Investors and advisors trade often, incurring unnecessary costs and have a wrong asset selection ability and top it off, they often have a concentration of risk. The real risk adjusted returns come from well diversified low-cost portfolios.

Gordon Robertson MCSI

Me Group

Director

T: +971 50 8459216

E: gr@me-group.ae