Dylan Emery reports on Martin Cambridge's speech at International Investment's South Africa Conference 2001, where he discussed managing client expectations
Managing client expectations and their psychological health is a key part of the role of an adviser, according to Fidelity's Martin Cambridge. A certain amount of manipulation is required to protect investors from their natural tendency to panic.
He says: 'The key challenge from all of us is to respond to client expectations and if we can understand the emotional and physical driver of client behaviour, it makes it easier to address their concerns. When things get volatile and a little bit crazy, investors seem to make even worse decisions than they do normally.'
Efficient market theory states that stock markets at any time reflect all known information so, in short, anomalies should not occur. But the so-called 'behavioural finance' theory holds that markets are not completely efficient. To understand common investor mistakes you have to identify what those errors are, then you can counsel them and make sure they do not happen again.
Cambridge described several typical client types/situations and analysed them.
A client has seen 20% returns over the last several years and expects to be able to replicate these into the future.
'This is simply not going to be possible,' Cambridge points out. 'If you talk to most investors they will overestimate the returns they think they are going to make, underestimate the amount they will have to save and they will be overly cautious on risk. That's quite a challenge for you.
'Our industry often looks at risk as price volatility, but investors look at risk slightly differently. Their risk is actually coloured by a lot of emotion: hope and fear.'
These emotions are what change risk tolerance. Investors have different tolerances at different times and those tolerances change as lifestyles change.
The investor sees the stock markets dropping and wants to pull out of equities entirely.
Initially, the fear side of the equation appeals as people hate to lose money. We have something inside us that is loss-averse. If we make a loss, we are very regretful.
'Of course, they can stop investing, which is what they initially want to do,' Cambridge points out. 'And this will eliminate the fear of regret. But then they will lose out on any future change of the market because when the markets bounce, they will miss out.'
Alternatively, they can sit tight, so based on the advisers' advice, they might carry on investing. Interestingly, the investor who sits tight will go through less pain of loss because you have warned them.
'The immediacy of recent events is quite powerful. For example, 11 September has had a powerful effect on everyone. You have to try and counter that emotion and put some reality back into the situation.'
The overconfident investor
'The DIY investor is particularly prone to overconfidence,' says Cambridge. 'What happens is they have lots of access to data, which they mistake for knowledge and think they can call the shots on their own without any advice. Behavioural finance has shown that overconfidence in an investor leads to overtrading.'
Fidelity did some research into the difference between DIY investors and advised investors. In terms of fund flows, DIY investors are much more volatile ' they all go in herds, typically just before the peak.
'So when you see the DIY investor rush in that's a good indicator to get out,' he says.
An investor with seriously underperforming funds but is unwilling to sell.
'Investors compartmentalise investments into different mental accounts,' says Cambridge. 'So once an account is opened they keep it separate. They see that it has made a loss, but they hold on hoping it will come back to break even. They do not admit there is a better deal elsewhere.'
If you understand the framework where these investors are coming from, you can counter that approach.
He mentions that a US stockbroker did some research and came up with the phrase 'we suggest you transfer your assets to another account', rather than 'we suggest you sell' or 'we suggest you close the account'.
This was more acceptable because those last two statements crystallise the loss in the client's mind.
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