Emotional Insurance

Classical finance theory makes little room for sentimentality when deploying wealth in the quest for returns. But the surprising reality is that the failure of economic theory, and subsequently the financial services industry, to address the importance of emotion in investing is one of the primary sources of poor advice to investors.

The industry’s traditional approach has essentially been to hand over ‘optimal’ portfolios built on the assumption that the investor will be completely focussed on long-term financial objectives at all times: ‘Here’s your ideal portfolio; it’s mathematically optimal for your level of long term risk tolerance, and financially efficient. Now it’s your problem!’ This places a huge practical and emotional burden on investors – making it their problem to actually implement the portfolios and then to manage them through the often quite dramatic ups and downs of the investing cycle.

In borrowing the glib assumption of complete rationality from the theorists, the industry has been washing its hands of responsibility for a large part of good investment decision making –not just knowing what to invest in, but also effectively acting on this knowledge and controlling one’s normal human emotional responses along the way.

By ignoring the important role of emotions, traditional portfolio solutions end up making investors uncomfortable along the journey and that frequently leads to poor decision making and lower performance.

When we’re stressed, we naturally take decisions that help us to get more comfortable:

• we pay too much attention to the short-term
• we over-react to market movements
• we invest in local assets or ones we’re familiar with and shun similar (or better) risks which are less familiar
• we buy when markets are doing well and sentiment is high, and sell when markets are low
• and we retain large portions of our wealth in cash, unused and unproductive.

On average, all these behaviours drag down long run returns. Despite what theorists may tell us, however, none of these is necessarily ‘irrational’. We do get something in return – we get to sleep at night! The truth is we need emotional comfort. But a sequence of comfortable short-term decisions doesn’t often add up to optimal long run performance.

Many investors sold in despair at the bottom of the markets in late 2008 and early 2009. In one sense, this was perfectly reasonable: if you’re stressed, anxious, or even terrified that markets will keep falling, selling out provides an instant sense of relief from knowing you won’t lose any more.

But this is short term emotional comfort purchased at enormous financial cost. Once you’ve left turbulent market for emotional reasons, it’s almost impossible to get back in again, no matter how good the logical case for it. You lock in the losses and miss the eventual rally.

So, how much should you pay for emotional comfort? Traditional finance says ‘zero’: emotion is to be controlled, not pandered to. But when we aim for perfection, betting against the obvious and powerful force of human fallibility, we often fail completely and pay a huge premium to eliminate our emotional turmoil.

One easy and natural way of purchasing emotional insurance is simply to take less risk. But this can also be very expensive. It reduces long term returns, sometimes dramatically. When offered a choice between the scary but mathematically perfect portfolio, and not investing at all, many choose the latter because it’s more comfortable.

By not investing, a moderate risk investor in a globally diversified portfolio foregoes long-term returns (averaged over many years) of about 4%-5% per year – a large amount to pay to ease discomfort! Just as it’s not rational to aim for an ‘optimal’ solution that you know is unattainable, particularly when the costs of failure are high, it’s also not rational to not participate at all purely for reasons of emotional comfort.

The right approach is to accept the need to sleep at night, and then ask how this can be best achieved. Identify the aspects of investing that make you most nervous and find targeted ways of reducing this anxiety as cheaply as possible.

At Barclays we use our proprietary Financial Personality Assessment to assist with this. It measures six different dimensions of your emotional responses to investing: three related to different aspects of your risk attitudes; and three to your decision making style. We use this to guide the selection of solutions that focus on providing the specific emotional comfort that is most psychologically important to each individual investor.

This may be achieved by keeping some reasonable portion of your wealth in cash for security. It may mean purchasing downside protection in the event of extreme market moves. Or it may mean sacrificing some long term upside to focus the portfolio on investments that feel more comfortable. But all of these mean you can invest your wealth productively for the long term, and get to sleep at night. Yes, some people need a little more emotional comfort than others – but no-one needs to pay 5% of their wealth per year to get a little rest. In investing, as with every in life, do not let the ‘best’ be the enemy of the ‘good’.

Greg Davies PhD
Head of Behavioural and Quantitative Investment Philosophy
Barclays Bank Plc

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