Financial professionals only
As soon as people move past the very start of their career, they begin to save. And then they experience a new range of feelings about money. These feelings can be unexpected, unfamiliar, and very hard to handle. So how can financial advice prevent them getting in the way of achieving the goal of financial wellbeing?
Principal among feelings about money for savers is loss aversion. In other words, the discomfort felt when you anticipate that something valuable might be taken from you, or lost in future. If you do experience an investment crash, powerful emotions of hurt, vulnerability and injustice are stirred. There’s a more powerful reaction to a loss than to a gain, for most people. Perhaps because, too often, silly analogies are drawn between long term investing and gambling.
Monkey business
To explore this phenomenon, behavioural scientists have taught capuchin monkeys to understand money and tested their “investors” for the same asymmetric loss reaction that we humans, the smart ones, experience. They found that monkeys, like us, get that bit more upset when they lose money1.
These hard-wired feelings are so powerful and difficult to control that investment businesses have to condition their clients to see through the emotions, with demonstrations based on evidence and logic. Typically, these are promoted as ‘golden rules of investing’.
Some Golden Rules
Here are a few examples of these ‘golden rules’.
- Cash is not always king. If you want to protect your money from inflation, invest it.
- It’s not timing the market, it’s time in the market. Taking your money in and out will mean you miss some crucial days when the market leaps ahead.
- Harness the power of compounding. Leave money invested for a long time and you could see a surprisingly high return.
- Diversify your investments. Spread the risk for the possibility of a better return for each unit level of risk you’re taking.
- Volatility is normal. Rewards can come from staying in the game – so hold your nerve.
There are a whole range of charts and graphs to go with each of these ‘golden rules’ which try to help the rational mind control the emotions around potential loss. After a few years in the industry, you will have seen them all.
Risk: a tougher nut to crack
The Initiative for Financial Wellbeing explores and researches ways of improving our relationship with money through the power of advice and the development of technology. Possibly one of the hardest areas to achieve this is the area of risk-taking.
The FCA’s suitability requirements place a responsibility on advisers to only recommend investments consistent with someone’s risk tolerance. So, the question is: should psychometrics trump financial planning logic when it comes to setting the risk budget? Should we let the inner monkey do what it thinks best, or work a bit harder for a good outcome?
As a case in point, a young person with a very low risk tolerance desperately needs adviser support to avoid massive disappointment with their retirement savings. If their chosen investments are based solely on the outcome of their risk aversion test, they may fundamentally impair their final outcome by investing without taking adequate risk.
What’s the prescription?
A doctor recommending the most effective treatment will always consider the possible impact of its side effects. Likewise, advisers aiming to promote financial wellbeing will consider if a suitable risk level is the level of investment risk most likely to give a good outcome, viewed in the context of a client’s capacity for loss and an assessment of their emotional robustness around uncertainty.
1M, Keith Chen & Venkat Lakshminarayanan & Laurie R. Santos, 2006. “How Basic Are Behavioral Biases? Evidence from Capuchin Monkey Trading Behavior,” Journal of Political Economy, University of Chicago Press, vol. 114(3), pages 517-537, June.
Other articles in this series
Money & Happiness pt.1: Starting with nothing ➜
Money & Happiness pt.3: Having it all ➜
This article is for financial professionals only. Any information contained within is of a general nature and should not be construed as a form of personal recommendation or financial advice. Nor is the information to be considered an offer or solicitation to deal in any financial instrument or to engage in any investment service or activity. Parmenion accepts no duty of care or liability for loss arising from any person acting, or refraining from acting, as a result of any information contained within this article. All investment carries risk. The value of investments, and the income from them, can go down as well as up and investors may get back less than they put in. Past performance is not a reliable indicator of future returns.