BackInvestors thinking about the short-term is a universal problem
Morningstar Inc.'s Sarah Newcomb talks about how behaviour of investors across developed countries like the US and developing nations like India is similar
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Mumbai: Experts and financial advisers say that investing is 99% investor behaviour management and 1% money management. The good news is that Indian advisers are not alone in this dilemma. Sarah Newcomb, behaviour economist, Morningstar Inc., an investment research and investment management firm, spoke to Mint about how it is a universal problem and investors in even developed countries tend to think short-term. The not-so-good news is that there is no clear answer yet, on how to influence investor behaviour to instill good habits. Newcomb’s research at Morningstar includes incorporating human behaviour traits into tools meant for financial advisers to better analyse the client’s risk profiles. Edited excerpts:
Indian investors don’t quite follow their risk profile. They take a risk profile test but whatever the results evaluate them to be, they react very differently in crunch market situation. Is it the same with US investors or are they more in sync with their risk profiles?
Oh yes. That is not a cultural problem. That is a human problem. We are pretty bad at predicting as to how we are going to behave when we are stressed about money. You can ask people what their thoughts are or how they are going to behave or feel, but it’s very different when you are actually watching your portfolio shrink.
But the US is a developed nation with years of investing history.
True. But that is one of the biggest frustrations that (financial) advisers in the US are trying to solve as they don’t seem to measure risk very well.
There was an interesting medical study done to understand why people’s risk profiles change. A group of people were made to take the risk profile test. Then, over the course of 8 days, they injected half of them with cortisol injections. Cortisol is a steroid hormone that goes up when the person experiences stress.
Then, they were monitored how they invested and behaved over different market scenarios.
It was found that those with cortisol shots injected in them suddenly saw their risk profiles change when equity markets went up.
So, their attitude or risks were dependent on the hormones in their blood. This showed that when you are under stress, you have a very different risk tolerance than what you may have originally suspected it to be, when you took the risk profile test.
So when we’re assessing people and asking them how they’d react when they would see the portfolio shrinking before their eyes, we are asking them in a calm setting. On another day, how they will react in a stressful situation is different altogether.
Another problem peculiar to Indian investors is that most of them think short-term. They seldom plan long-term. How did people start thinking long-term in the US?
This is a universal problem as well. We have different types of investment strategies, some investors take the long-term view and pick an asset-allocation strategy and invest in index funds and are value driven. That’s what we at Morningstar advocate as well: long-term and value-driven investment, rather than relying on chasing returns in the short-term.
But the reality is that stock picking is fun. And we all want to pick a winner. So it is universal. In fact, discounting the future and being short-term focused is probably the most universally damaging factor in the human mind on money management. Because we discount the future, we see the immediate returns of anything as bigger and things that are set out at a distance, in our mind’s eyes seem smaller.
That is why we don’t wait to take a smaller reward now over bigger rewards later. And if we have to pay the cost for something now, we feel that pain greater than if we think of paying that cost later.
So our mental models of time and money really mess us up. We have to find ways to overcome that. Behavioural scientists have found that some of the solutions work in the laboratory with college-going kids, but we need to work towards bringing the solutions to the financial adviser’s office.
I am hopeful. Look at me. I was a financial mess and had nothing to do with numbers. I knew math and numbers, but money management is a lot about emotions and mental stories than it is about numbers. So I got into this line of work because I wanted to get to the root of my own issues. And if I can change—I was a financial mess—then I believe other people can. So I am very hopeful.
Indian investors are often torn between fixed returns (such as bank fixed deposits) and variable return (equity) instruments. Administered returns, though, are going down. In the US, your pension money like 401(K) plans is in equities. How do you change people’s mindset to include variable return in their portfolio?
We’re talking about risks and being comfortable with risk. And if it is variable-return instrument like equity, it comes with more risk than something that grows slower and safer.
People need to know that it’s possible to invest in equities without losing everything, provided they have a well-diversified portfolio; one that has some slow-and-steady turtles that are just going to anchor you portfolio and protect some of your principal.
You would still need to stomach the ups and downs. But you would at least know that even if the markets drop, you’re still going to be okay because a part of your portfolio is in fixed income. It’s important to not just diversify across industries but also across asset classes.
In the US presidential elections, we have one candidate taking extreme positions. What explains the popularity of such extreme positions?
I can often find emotional intensity and passion to be very convincing because it’s a human experience where rational thoughts seem simply less interesting. Often, emotionally charged arguments can sometimes lend a feeling of credibility regardless of whether or not there is substance behind it. Emotion resonates with people
It’s the same thing when we talked about taking risk with respect to our money management. How do we get ourselves to make rational long-term decision despite the fact that we are driven by the short-term emotional instincts? It’s kind of similar.
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