Predictability is a key tool for the mindful investor
Few investors like to admit their decisions are influenced by anxiety, yet with nearly a quarter of the adult population claiming to have persistently high anxiety it is unlikely that the investment community is exempt.
There is a strong body of evidence that suggests that the performance of the stockmarket is correlated to how people feel. Indeed, some academics claim they can demonstrate that events as arbitrary as dropping out of the World Cup, a new comedy film being released and religious festivals can be shown to affect optimism levels amongst stockmarket investors to a measurable extent.
A more serious effect however is found in the way anxiety affects investors’ long-term outcomes. Research has shown (Kim 2018 [i] ) that individuals prone to high anxiety levels have lower stockmarket participation throughout their lives, meaningfully affecting their retirement outcomes. They tend to be less likely to invest into markets – struggling to cope with the inherent ambiguity – and then struggle to stay in when markets fall.
This particular problem is associated with that large portion of the population that have what psychologists term ‘high trait anxiety’. Those of us who fall into this category are capable of making many irrational economic choices simply to reduce future uncertainty.
Anxiety can cause all manner of poor behaviour from investors. It tends to cause us to see patterns that do not exist (Whitson and Galinksy [ii] ) and the cortisol it produces leads us to fight by digging in to our pre-existing assumption even as the evidence changes or flee and sell our investments.
Crucially, as the vast majority of investors today complete a risk assessment designed to understand not just their capacity for loss but also their appetite for risk it is important to distinguish the role of anxiety from simply choosing the right level of risk to take.
Caplin and Leahy [iii] argue that; ‘anxiety is an anticipatory emotion experienced prior to the resolution of uncertainty. It is related to the feeling of living with uncertainty. In contrast, risk aversion is a static concept pertaining to the curvature of the utility function within a period.’
In other words whilst calm, rational risk aversion can help position an investor at the right place on the efficient frontier of risk and return – anxiety only moves them away from it.
The key to tackling this challenge is of course primarily good financial advice. Financial advisers are capable of anticipating those individuals prone to such anxious traits and intervening to protect their long-term outcomes at critical market junctures.
However, there are also actions that a portfolio manager can take.
The first step is diversification. Diversification necessarily lowers the range of plausible outcomes for any portfolio, hopefully reduces sharp drawdowns and creates fewer scenarios where a high trait anxious investor will be influenced to the point of making an irrational investment decision.
However, at Atlantic House Investments we believe a second step is also valuable. By drawing on asset classes which forego some upside in exchange for creating a high probability of a ‘good’ outcome, and by offering clear guidance on how an investment will behave in future market scenarios, we believe investor anxiety could further be reduced.
The Atlantic House Defined Returns fund is able to offer investors confidence that a 7-8% annual return can be achieved over the long-term except in the bleakest market scenarios.
Such an offer comes at the cost of foregoing returns above this level and cannot mitigate for all of the market volatility associated with investments linked to equity markets.
High trait anxiety is a tendency to want to remove ambiguity even if it comes at a cost, to reduce uncertainty even if it involves foregoing some upside. Providing a journey that captures the equity risk premium for investors over the long-term whilst mitigating for many of the scenarios that could lead them to sell their investment surely has a value.
For this reason, we believe defined return investments can play a modest but important role as part of the broader work of financial advisers and portfolio managers in creating resilient portfolios, even for our more anxious investors.
Past performance does not predict future returns. The value of investments can go down as well as up and you may not get back the full amount invested.
[i] Lim, Yuree, and Kim, Kyoung Tae. “Afraid of the stock market”. Review of Quantitative Finance and Accounting, Volume 55, 2019.
[ii] Whitson, J. A., & Galinsky, A. D. (2008). Lacking control increases illusory pattern perception. Science, 322 (5898), 115–117. https://doi.org/10.1126/science.1159845.
[iii] Caplin, Andrew, and John Leahy. “Psychological Expected Utility Theory and Anticipatory Feelings.” The Quarterly Journal of Economics, vol. 116, no. 1, 2001, pp. 55–79. JSTOR, http://www.jstor.org/stable/2696443.