investor behaviour

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MasterMind: Inside an investor’s mind

3 potential solutions to Mr. A K Narayan’s challenge

In a nutshell

A few months ago, we carried a very insightful interview with Mr. A K Narayan, President, IFA Galaxy, in our Equity Insights microsite, where he explained some of the challenges in practically implementing asset allocation decisions. He took us through typical client responses when they review their portfolio statements, and how their thinking sometimes takes them far away from agreed plans.

MasterMind took up this challenge of trying to understand why investors tend to behave the way Mr. Narayan articulated so well, and then consider solutions to the challenge that he articulated. MasterMind – a joint initiative between Sundaram Mutual and Wealth Forum, aims to provide advisors with insights from the world of behavioural finance which can help you understand investor behaviour better and on the basis of this understanding, engage with them more effectively.

Here is an extract from Mr. A K Narayan’s interview (Click here for full interview):

“WF: Does portfolio rebalancing happen with clients as often as you ideally desire? What are the issues that come in the way of implementing regular portfolio rebalancing?

Narayan: Despite sincere attempts from our side, its not always possible to actually execute periodic portfolio rebalancing. Let me give you some actual experiences. So, when we talk about long term returns from asset classes, we generally discuss that debt should give around 7 – 7.5%, balanced around 10 – 11% and equity around 14 – 15% over a market cycle. Now, in good times, in the first couple of years, equity delivers at or above long term expectations, while other asset classes obviously don’t match equity. There are clients who will look at their portfolios and rue the fact that they put money into debt – had they put more in equity, they feel they could have made a lot more money. When they are in this frame of mind, try telling them to actually take out some money from equity and put into debt because they are overweight in equity!

Take another classic example: gold. For HNIs, we recommend a small allocation to gold funds – say 5% or maximum 10% as a portfolio hedge, as a portfolio diversification. When they see their portfolio statements and the returns on gold funds in the last few years, they invariably compare against other asset classes and keep asking us to exit gold funds and move the money to a better performing asset class.

The challenge is that while asset allocation makes good sense at the outset, for a number of clients, the context changes completely when they see their portfolio statements which show varying rates of return during the same period across different asset classes. The natural tendency is to back the winners – put more money into what has won in the last year, at the expense of those which lost the race last year.”

What Mr. Narayan articulated is a challenge that most distributors and advisors face. Why do investors agree on an asset allocation, agree for a diversified portfolio across asset classes, but then start evaluating one asset class’ returns vs the other – thus defeating the whole idea of diversification? MasterMind decided to take up this very real issue, understand why this happens and offer some potential solutions based on this understanding.

The pitfalls of narrow framing

Behavioural finance – which is devoted towards understanding why investors behave the way they do – has a terminology for this type of investor behaviour – its called narrow framing. As an advisor, you want your client to have a broad frame when evaluating portfolio performance. You want him to look at overall portfolio performance, you want him to see how you have controlled portfolio volatility with your diversification efforts, you want him to notice how you have smoothened his annual returns even during bad times for stock markets, since other asset classes are pulling their weight at that time.

But your client adopts a narrow frame, by choosing to evaluate every individual fund’s performance in relation to the best performing fund in his portfolio. The role of gold funds as a hedge against market dislocations is lost on them when they see the gold fund turning in a negative return while equity funds are doing well. The wisdom of an allocation to debt is lost in bull markets, and the wisdom of adding equity during bear markets is lost when equity funds are bleeding.

The root cause of narrow framing is regret avoidance

At the heart of narrow framing is regret avoidance. People regret making poor choices. “If only I had invested more in this fund, rather than in the other one”, is an all pervasive sentiment that advisors often encounter. Investors regret not investing more in the fund that topped the league table last year, and regret having diversified into other funds. That’s exactly the investor sentiment that Mr. A K Narayan explained in his interview.

Regret avoidance refers to actions that investors take to ease the emotional pain that regret may cause them. If an investor believes – based on the last 6 months performance – that he would have been better off investing more money in the best performer and exit others – he perceives a lot more pain ahead in the coming years, by sticking with the “sub-optimal” choices in his portfolio. In order to avoid that pain – in order to avoid that feeling of regret, he wants to switch from underperforming funds and asset classes to outperforming ones. It is not so much the actual performance over the last 6 months that gets him worried – it is his own extrapolation of this trend into the future, and the keenness to avoid a regret of having made a hugely wrong choice, which makes him jumpy. That’s what makes him disregard your advice on diversification – because what he sees at this moment is one good decision and many poor decisions – which are going to pull down his portfolio performance big time.

3 potential solutions for narrow framing

So, how can an advisor help his client overcome narrow framing that is a result of regret avoidance? There are three possible solutions – advisors need to decide which one or which combination works best for individual clients.

    1. Education

We have all come across and used charts and tables which show how different asset classes are winners in different years, and how different sectors are winners within equity in different years. It is important, when casting a diversified portfolio the first time, to take your clients through the need to diversify and the perils of chasing past performance. Leave behind these charts and tables for your clients to mull over after the meeting. Remind your client about this conversation, when you see him falling victim to narrow framing and wanting to make inefficient portfolio decisions.

    1. Tactical and strategic allocations

If you know that narrow framing is not possible to avoid entirely with a customer despite your education efforts, agree on bifurcating the portfolio between strategic/core and tactical/satellite. Once you create a satellite portfolio which will be managed purely tactically, you will find many clients willing to take that “long term view” on the core portfolio which you want them to take. The key is to manage the satellite portion as actively as you can and as actively as the client wants. Tactical calls are all about which idea you believe is likely to deliver the best absolute returns across all asset classes over the next 12 months. Get the narrow framing focused on the satellite portfolio, instead of the whole portfolio.

    1. Bundled solutions

Behavioural scientists believe that bundled solutions are perhaps the best solution to get around narrow framing. Narrow framing happens only when the client sees individual fund performances, and loses track of what this fund’s role is in his overall portfolio. A debt fund that was chosen as part of a higher education plan that is due in the next 3 years, looks like an underperformer vs an equity fund that has been selected as part of a retirement savings plan, due in 12 years. When both are reported one below the other in a portfolio statement, there is a tendency to compare lower returns of the debt fund against much higher returns of an equity fund in a bull market, and thus prompt some thinking around whether to exit the debt fund and add to the equity fund. Portfolio software nowadays have the capability to report goal wise performance. That’s a step in the right direction, but it still does not eradicate individual fund performance reporting. This is where bundled solutions can play a role. A multi-manager fund of funds product that is reported as a single investment, but is actually an amalgam of different funds with a pre-defined asset allocation is one such bundled solution that avoids reporting of individual underlying funds. Asset allocation funds with different variants of allocation between debt and equity can also help. If your reporting software throws up only goal based performance reports at an aggregate level, without monthly/quarterly reports at a fund level, that will also help. The bottom line is when you try your best to take your client away from narrow framing to broad framing, but it doesn’t work, you may need to find ways of investing in broad based embedded asset allocation solutions that take away the risk of narrow framing, and help your client stay on track.

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