While it is good to have an understanding of the concepts behind behavioural finance, it is better to have an understanding of oneself. I think it is essential to take time to get to know our own responses to different situations. The problem is we are really good at deceiving ourselves. There’s quite a lot to take in in this post and the next, but I felt it was important to present it to you in this way.
Looking Closely at How you Feel
There’s an abstract, theoretical part to this and a practical, hands-on part to it too. For example, when markets are riding high, and every time you log in to your investment account, you see that it has increased in value.
If I ask you at this point about how you would react to a 20% decline in the value of your investments, you’ll be dealing largely in the theoretical arena. Chances are, you’ll be fairly sanguine about the possibility, because it is only a possibility.
If I asked you the same question right after you logged in to see your investments are actually worth 20% less, then if I asked you how you are reacting, then that would of course be a much more reliable answer.
In quarter four 2018, markets experienced their worst quarter since the financial crisis of 2008. Sod’s Law dictated that the high-ish point of the market corresponded to about the start of the quarter, and the lowest point right at the end.
When our clients here at Jacksons received their quarterly statements, it looked about as bad as it could. Fortunately, by the time the statements were received by the clients, the markets had recovered quite a bit. But we had some phone calls, I tell you. Nobody was panicking, but the decline was enough to make them worried.
I had a call with a client in March 2019, and during our conversation, he said that he had been worried in quarter 4 of 2018, watching his portfolio decline in value by 10%. He’s at the cusp of retirement, so he’s obviously protective of what he has built.
His words to me were that a 10% decline was tough to watch, and he didn’t know what he would have done had the value dropped by 30%. Now, I’ve measured his risk tolerance using the barely-fit-for-purpose questionnaires advisers use for such purposes, and on paper he can cope with the level of volatility he has experienced recently. But when it actually happens, and the rubber hits the road, that’s when you KNOW how you feel about it.
So how do we navigate this? Do we all head off to Vegas with our pensions funds and punt some of it, just as an experiment in behavioural finance? Of course not. But as we’re looking at New Accumulators, it’s hard to move into the realm of practicality just yet, so all we can do is thought experiments for now.
Here are some questions you can ask yourself:
a). Do I have enough set aside so that I can largely ignore my investments?
There’s a reason I bang on about an emergency fund as a kind of life buffer. If you know you have cash put aside for pretty much anything that you’re likely to need in the short term, the day-to-day ups and downs of your investments recede in their importance.
Taking this to the extreme, I have a client who keeps £250,000 in her current account, which is financial lunacy, but it means that she can push the risk of her other £250,000 because she’s investing it for her family.
She may need it if she needs long-term care in the future as she’s fairly elderly, but the fact that she doesn’t worry about her investments is predicated on the fact that she’s got all this money in the bank. She knows it’s there when she needs it.
b). If I have £5,000 invested, and I see it turn into £4,000. How will I feel?
Again, this is entirely theoretical, but worth considering. Try to imagine opening a statement a year after you have invested and your fund is worth £1,000 less than it was at the start. If the numbers aren’t big enough for your specific situation, multiply them by ten. How would you feel if £50,000 became £40,000?
Bear in mind the previous question – you don’t need to access this money, but it’s still your money; how would you react? You have to really imagine this, and it’s more than an abstract thought experiment – you almost need to put yourself in that position.
c). If I can’t access my pension for another 30-odd years and I see its value fall from one year to the next, will I adjust my investment approach?
This question takes away the accessibility factor. You can’t take money out of your pension because you’ll your 20s or 30s and it’s inaccessible by law. But will a sharp decline in the value of your fund make you reassess your investment approach, maybe dial down the risk ‘until things get a bit more stable’? I’ve heard that many times over the years, but they never really get more stable.
Of course, if you have money invested already and you have seen it decline, then you do have an advantage over those that haven’t, because you now have the beginnings of a practical understanding of how you behave around investment volatility.