How much are you prepared to give up in order to sleep better at night? A strange question, perhaps, in the context of investing. But it's one that needs to be asked (by you) and answered (by your client.)
Classical finance theory makes no room for such luxury when considering how to best deploy personal assets in the quest for investment returns. But classical finance theory often fails to capture the real-life concerns of investors. In fact, the failure of economic theory-and subsequently the financial services industry-to address this question is one of the primary sources of poor advice to investors.
The traditional approach of the industry has been to create "optimal" portfolios that presupposes that the investor is completely rational at all times.
The industry has been effectively washing its hands of responsibility for a very large part of what it means to invest well. It's not enough just to know what to invest in. It's also necessary to effectively execute on this knowledge and to control one's very normal emotional responses. By ignoring the important role of emotions, traditional portfolio solutions not only make investors uncomfortable, but they also potentially result in poor decision-making and lower performance.
As creatures of emotions, when we're stressed we make decisions that make us more comfortable. We pay too much attention to the short-term; we overreact to market movements; we invest in local assets or ones we're familiar with and shun better risks that are less familiar; and we retain large portions of our wealth in cash, unused and unproductive.
A sequence of comfortable short-term decisions often does not add up to optimal long-run performance. In other words, these behaviors drag down our long-run returns.
But bear in mind that these reactions are perfectly normal. So how do you incorporate them into an overall investment strategy?
First, identify the issues at play. Despite what some behaviorists say, these reactions are not only natural, they are often rational. Yes, they can reduce long-run returns. But we get something in return-we get to sleep at night!
Many investors sold out in despair at the bottom of the markets in late 2008 and early 2009. In one sense, this was a perfectly reasonable thing to do. If you're stressed and anxious about the markets, selling provides a sense of relief. This is short-term emotional comfort purchased at enormous financial cost, however. Once you've sold out of a turbulent market, it's almost impossible to get back in quickly. You lock in the losses and miss the potential market rally.
This brings us back to the question: How much should your clients pay for emotional comfort? Traditional finance says "zero." Emotion is to be controlled, not pandered to. But when we aim for perfection, we're betting against the obvious and powerful force of human fallibility.
One way of purchasing emotional insurance is simply to take less risk. But this also reduces long-term returns, sometimes dramatically. When offered a choice between the perfect portfolio and not investing at all, many choose the latter because it's more comfortable. In doing so, a moderate-risk investor in a globally diversified portfolio may be missing out on as much as 4% to 5% over what she'll get from holding cash. This isn't irrational because emotional comfort is important-but it's expensive. The right approach is to accept the need to sleep well at night, but then try to achieve this as cheaply as possible.
This may mean keeping a reasonable portion of your wealth in cash; purchasing downside protection in the event of extreme market moves; or even accepting some inefficiency in your portfolio.
All of these can help you invest productively for the long term and get some sleep. Some people need a little more emotional comfort than others. But no one needs to pay 5% to get it.
Greg B Davies, Ph.D., is managing director and Head of Behavioral and Quantitative Investment Philosophy at Barclays Wealth.