Yemisi Izuora
Experts have identified proper managemen of “emotional” investment returns, and the way investors implement diversification can have an impact on how their investment returns affect them.
This can, in turn, impact future investment decisions which could be detrimental to investors long term financial returns.
Speaking on what happens to an investor who got intrigued by call for diversification, a Nobel prize winner, Richard Thaler, said there are two potential ways to achieve this.
According to Thaler, one way is to invest equally in two different funds while the other 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”,said Thaler.
Thaler, established that many people have a tendency called “mental accounting” that often prevent them 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, he gave 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 per cent (loss of 3.8 “emotional points”) through to the peak in the US stock market and then a gain of 0.7 per cent (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 per cent 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 per cent (4.6 “emotional points”) through September and then a loss of 7.1 per cent (-14.2 “emotional points”) in the remainder of the year for a net -5.6 “emotional points” loss.
He concluded from the analysis that 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.” Thaler concluded.