The most common and potentially costly mistakes made by investors have little to do with rational decision-making, writes Natixis Global Asset Management’s David Goodsell.
It will come as no surprise that an investor’s best chance of success is to set clear financial goals, establish a plan to achieve them and then stick to the plan through thick and thin.
At the same time, one of the most surprising findings from our 2016 survey of financial advisers was that the most common mistakes investors make owed to the fact they’re human – meaning they often make decisions based on irrational emotions, outsized expectations and poor planning.
So what should investors do?
There are five key do’s and don’ts that our survey of financial advisers revealed, which if heeded, with the help of professional advice, will improve investor outcomes.
Do avoid emotional decisions
Investors may think they are objective, but when markets are volatile, many operate on fear.
Our 2016 Global Survey of Individual Investors revealed that more than six in ten investors worldwide believe market volatility undermines their ability to reach their savings and investment goals.
Two-thirds admit that they feel helpless in protecting their portfolio from volatility – it’s this mindset that can often lead investors astray.
Many investors fail to recognise the impact that emotions have.
Only three in ten investors believe that they could actually do better if they avoided emotional decisions, whereas the reality is that financial advisers understand that a thoughtful, measured approach is more likely to result in success.
More than half of investors worldwide say they struggle to avoid emotional decisions when market shocks occur.
The problem is that investors are very quick to panic when markets go down, but less surprised when they go up. Knee jerk reactions are not a recipe for success.
Don’t have unrealistic expectations
Investing is an optimistic pursuit, we invest money with the hope that it will grow over time, but beware of optimism becoming unrealistic expectations about just how much an investment will grow.
This is where financial advisers play a crucial role in helping to temper expectations and provide a realistic view.
Of the 7,500 individuals in our investor survey, 70 per cent said that the annual return needed to achieve their long-term goals is 9.5 per cent above inflation, and 64 per cent of investors believe these expectations are realistic.
In our current low-growth world, financial advisers have a more realistic view.
On average, advisers say returns of 5.8 per cent above inflation are more likely. In other words, investors’ expectations are an average of 180 per cent greater than those of the professionals.
The issue is that high returns require investors to take on higher risk, including investments in riskier asset classes – which many do not fully understand.
On the other hand, too great a focus on investments perceived as low risk can be risky in itself.
Many investors believe, for example, that index funds are a relatively safe way to invest, and recognise the basic arguments in favor of passive investing – 70 per cent said index funds give them market returns and 62 per cent that index funds are cheaper.
The problem is that 60 per cent believe index funds are low risk and will protect them from losses.
The truth is, however, that unlike active investments, index funds have no built-in risk management to protect against a loss.
Advisers understand this - over 70 per cent say investors have a false sense of security when it comes to index investing and are unaware of the risks.
Do ignore short-term market noise
Advisers said that even their most disciplined clients, those with long and short term goals-based investment plans, still regularly fall victim to short-term market noise and struggle to remain focused on their goals when short-term shocks hit.
Unfortunately, focusing only on the short-term is a mistake in both good and bad times.
Investors’ herd instinct to buy into the momentum of a rising market can be just as strong as the desire to flee a sinking market – and in both cases can result in buying high and selling low – not a recipe for investment success.
Do have a financial plan
It goes without saying that a financial plan is a pre-requisite to success, yet advisers tell us that many investors are still lacking this most crucial foundation.
This year’s survey was no exception – 51 per cent of investors say they have no clear financial goals and 63 per cent have no financial plan.
These figures are particularly concerning when set against what most investors say is their highest financial priority – retirement.
Many investors underestimate what they will need to live on in retirement, with most saying that 61 per cent of their pre-retirement income will be sufficient, where on the other hand, advisers and experts put the figure at closer to 75-80 per cent.
It’s no wonder that the biggest challenge advisers see in building retirement income portfolios is generating income above and beyond basic necessities.
Investing for retirement income introduces a number of new variables, including generating stable income, growing assets while managing volatility risk, accommodating drawdowns while continuing to grow the portfolio and generating returns that beat inflation.
A financial plan won’t make these problems go away, but it will increase the likelihood that investors have them in mind as they set realistic savings and investing goals.
Do know how much risk you can really tolerate
When asked what risk means to them, investors universally agree that “loss of wealth” is the biggest risk of all.
Unfortunately, when it comes to their investment decisions and behaviours, many forget to put risk first and can behave in a way that is more, rather than less, likely to result in a loss of wealth.
For example, when asked how they would respond to a stock market fall of between 10 per cent and 20 per cent in a six month period, large numbers (42 per cent) say they would do nothing.
Almost the same number (41 per cent) say they would decrease their investment at least a little, whereas only 17 per cent say they would see the down market as a buying opportunity and increase their investments to equities.
On the other hand, advisers say they are more likely to make the counter intuitive decision to increase equity investments in a declining market.
Half of the advisers we spoke with said they would advise clients to increase their investments. This is closer to what highly knowledgeable institutional investors said they would do – 71 per cent said they would add to their equity allocations on a market decline.
The bottom line? Investors are on the right track
Investors see themselves as thoughtful rather than emotional when it comes to investing, believe they are confident - not fearful - and driven by research rather than instinct.
The challenge for advisers is to ensure that human nature doesn’t get in the way of investors’ good intentions.
Most investors acknowledge the crucial role that professional advice plays, seven in ten say investors with advisers are more likely to reach their goals, and two thirds that advice is worth the fee, which is good news for advisers and the investors they help keep focused.
David Goodsell is executive director of the durable portfolio construction research center at Natixis Global Asset Management.
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