Alexis Calla
In our 2019 outlook, one of the key
messages that we have constantly communicated over the years is the
importance of diversification. While we get the sense that some of our
investors have been
heeding this message, it is also clear that some are
yet to be convinced.
This year, in conversations with some
clients, we introduced the idea of “emotional” investment returns,
highlighting that the way you implement diversification can have an
impact on how your investment returns affect you. This can, in turn,
impact your future investment decisions which could be detrimental to
your long term financial returns. This idea clearly resonated with them
and we decided to share it more broadly.
One of my favourite books is Daniel
Kahneman’s Thinking Fast and Slow. Kahneman is a Nobel prize winner for
his research (with Amos Tversky) into behavioural biases. One of their
theories is “prospect theory”, which states that “the pain of losing is 2
times greater than the pleasure of winning”. Let’s examine the recent
performance of a couple of different asset classes in recent times to
demonstrate the importance of this finding.
One of the most popular asset classes in
2018 was US equities, which rose 11.2% from its start of the year level
of 5212 to its 5794 peak-level in September, before falling 14.0% from
the peak to its year-end level of 4984. From a “classic financial” point
of view, if this was the person’s only investment (let us say USD
10,000), the loss would have been 4.4%. Not ideal, but hardly the end of
the world. However, from an “emotional” point of view it was probably a
lot worse. Taking Kahneman’s 2:1 emotional cost/benefit ratio into
account, the investor would have experienced 11.2 gain in ‘emotional
points’ followed by a 28 points loss (2 multiply by 14), before arriving
at a net loss of 8.8 “emotional points”. What an emotional roller
coaster!
But what about an investor who got intrigued by our call for diversification?
There are two potential ways to achieve
this. One way is to invest equally in two different funds. The second is
to invest in a fund that has a 50:50 split between the two asset
classes. While they are financially equivalent (assuming the fund
manager invests in the same underlying assets), emotionally they can be
very different.
To work fully, financially as well as
emotionally, diversification requires investors to look at their
investments as a pool and not as a set of separate items. Another Nobel
prize winner, Richard Thaler, established that many of us have a
tendency called “mental accounting” that often prevent us from looking
at things in totality. What this means is we all have the tendency to
look at each individual line of an investment portfolio. This can
influence us to make sub-optimal decisions.
Developing the above analysis further,
let’s take the example of an investor who decided to split her US equity
investment, allocating USD 5,000 to global bonds. On this second
investment, she would have made a loss of 1.9% (loss of 3.8 “emotional
points”) through to the peak in the US stock market and then a gain of
0.7% (gain of 0.7 “emotional points”) in the remainder of the year for a
net loss of 2.4 “emotional points” over the year. The combination of
the two investments would have been a 4.6% gain through to the peak in
the US stock market and then a loss of 7.1% in the remainder of the year
for a net loss of 2.8% over the year. But “mental accounting” would
have prevented our investor from aggregating ‘emotional’ returns, the
equity allocation remaining a painful 8.8 “emotional points” loss.
However, for the investor who decided to
invest USD 10,000 in one fund that diversified across both US equities
and global bonds, her return would have been 4.6% (4.6 “emotional
points”) through September and then a loss of 7.1% (-14.2 “emotional
points”) in the remainder of the year for a net -5.6 “emotional points”
loss.
As you can see, the financial return is
clearly the same at each point, but the ‘emotional’ returns can be very
different if the investor mentally accounts for each individual
investment.
When using a balanced product, the
reduction in the ‘emotional’ pain during the equity market fall (-14.2
points vs -28 points) far outweighs the loss of ‘emotional’ gain up to
the peak period (4.6 points vs 11.2 points).
The risk of ignoring the investor’s
‘emotional’ pain would be so great that they would sell what is hurting
them. Not only could this distract them from their long-term objectives,
but in this instance, it would also have meant selling equities just
before the strong rally we subsequently saw since the turn of the year
(+11.8%).
Helping our clients make less biased
investment decisions is one of our key objectives at Standard Chartered
Bank. The above academic research, together with our day-to-day
experience with clients, suggests investors should allocate a
significant portion of their investments to core diversified holdings as
we believe this will help them manage their emotions and stay on track
when it comes to their long-term financial goals.
(Alexis Calla is Chief Investment Officer at Standard Chartered Bank).
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