This week I want to discuss another behavioural finance error or bias, which affects our investment decision making ability and that, is “Loss Aversion”. It has been proven that fear of losing money is more intense than the hope of gaining money, “loss looms twice as large as the possible gain”. Thinking, Fast and Slow, Daniel Kahneman
Unfortunately financial advisors are also prone to this bias, particularly if you consider the pressure from regulation, which incorrectly views risk as volatility of returns. Financial advisors are required by law to establish the risk profile of their clients and then to match the portfolio risk accordingly. This is completely and utterly flawed. It results in the financial advisor giving the client want he or she wants and not what they need. Let me explain further.
Portfolio construction begins and ends with the investment objective. The portfolio must be optimally invested to produce the return required to meet the investor’s objective. I use the analogy of a road trip to explain the concept of optimal investing. Let’s assume you are off to Cape Town and you know your car uses 1lt for every 10 kms, given CT is 70 kms away you will need to put-in 7 litres of fuel to reach your destination. Just the same the investor needs to take-on sufficient risk assets to achieve the returns required to meet the objective.
It is of no use to establish the personal risk profile of a client other than to test their understanding of investment theory. The personal risk profile of a client can be described as the clients risk appetite versus the required risk / return, which can be referred to as the clients risk budget.
In today’s world where unconventional monetary policy has effectively wiped-out the returns generated from traditional risk free assets of cash and bonds, investors who fail to take-on some risk assets stand the very real chance of saving themselves poor, as inflation erodes their wealth.
Mcomm, CFP®, HdipTax
T. 021-851 3746