Is investor emotion strangling your business?

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Many financial advisers continue to fall into the trap of reacting to client emotions, which can result in poor outcomes for both the client and the advice business. Scott Fletcher, head of strategic wealth and partner solutions at Russell Investments, says the inflow and outflow of funds from growth investments continues to match what he calls the “cycle of investor emotion”, irrespective of whether or not an investor used a financial adviser.

The fact, according to Fletcher, is that the inflow of funds into growth assets peaks when the market is at its highest and the outflow of funds from growth assets peaks when the market is at its lowest. In other words, retail investors buy high-growth, high-risk investments when they are at their most expensive levels and sell them when they are grossly under-valued, often realising big losses in the process. However, advisers have an important role to play in steering small investors away from this herd mentality.

“We find better advisers have more touch points with clients through the year. They are more likely to have closely linked investment strategy to the client’s goals so there’s more discipline for the client to stick with the strategy through tough times, less client churn and less clients running to cash at the worst possible time,” says Fletcher. “Advisers with less touch points who haven’t made a close connection between strategy and client goals are more likely to have clients turning up at their office completely scared and advisers are more likely to capitulate to their emotion to keep the client.”

Outcome-focused investing is the key theme for advisers who want to break away from the cycle of investor emotion, Fletcher says. This starts with the process of the adviser having a full and clear understanding of the client’s goals and the returns required to achieve those goals. The next step is to determine the right asset allocation to deliver the desired outcome.

According to Russell Investments, the three types of asset allocation are: strategic (long term), enhanced (medium term) and tactical. Tactical asset allocation involves timeframes of less than 12 months and is the most problematic area for advisers and retail clients. “We do not recommend that retail investors or advisers engage in tactical timing as the evidence shows it ends up eroding wealth,” Fletcher said. Where advisers don’t have the necessary investment skills in-house, they can choose to completely outsource active asset allocation (eg strategic and enhanced asset allocation) to investment experts.  Alternatively, advisers sometimes choose to use model portfolios or they can tailor-make individual portfolios for their clients.  In these cases, advisers may do active asset allocation in-house but need to remember the additional compliance risks and admin costs they are bringing into their business.

Once asset allocation is discussed, the adviser and client need to agree that the level of risk needed to achieve the desired outcome is acceptable. Goals and strategic asset allocation need to be reviewed until the client is comfortable with the level of risk required. Obviously Russell Investments advocate the complete outsourcing of asset allocation and management, but acknowledge that the approach taken by an adviser depends on the business and remuneration model used. Russell takes a multi-asset (or multi-strategy) to deliver specific investment outcomes such as real return and risk.  A key focus is to deliver real return outcomes with acceptable levels of volatility for the client, remembering that lower volatility means a higher probability of success. Portfolios are designed for a range of client risk profiles: A conservative multi-strategy portfolio should typically achieve an average real rate of return (after inflation) of around 2%pa over a rolling 5 year period; while a growth portfolio should average more like 5%pa after inflation over the same timeframe.

The bottom line for any adviser is to take an approach that will enable clients to avoid the most commonly-made mistakes in downturns. The first is to run to cash at a time when term deposit rates are falling and the use of hybrids may not be fruitful in the longer term. At the moment, defensive assets are “expensive” whereas growth assets, such as Australian shares, are relatively cheap, because the Australian share market is still lagging behind international markets.

Another common mistake is that clients will expect more of their advisers in tough times and as a result you’ll need to resist the temptation to time markets or “want to be seen to be doing more” in order to keep the client happy. Abandoning a long-term investment strategy completely because the client is tired of having made no progress for a couple of years is another typical mistake.  These types of mistakes result in underfunding client retirement goals.

 

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