Tools from behavioural finance can help investors mitigate panic during periods of market volatility, helping them to avoid selling at the wrong time and missing lucrative market rebounds.

The investment industry currently tries to achieve two conflicting aims: to deliver the returns that investors need to reach their goals and to avoid volatility that might lead them to abandon their investment plans. There is a difference between investors’ capacity for risk – they have the financial means to cope with market downturns – and their desire to avoid market downturns at all costs.

Sometimes the returns investors need to reach their goals may require exposure to assets that they would prefer not to have. Often mixing the two approaches, maximising returns while shunning volatility, leads to neither being achieved successfully.  A commonly used tool is to increase bond exposure and reduce stock market weighting as the target date for an investment plan approaches.

Asset allocation is an appropriate and powerful tool, but on its own, it may not be enough to help investors handle risk. Behavioural tools that help investors prepare for and respond to volatility when it comes — are more appropriate. The tools can address the discomfort directly or provide other ways to manage volatility. Here are some potential techniques:

  • To reduce panic selling, the financial-services industry can better package long-term investments as “set it and forget it” tools
  • To alleviate loss aversion, investors can avoid checking fund prices too often, ie. on a daily basis
  • To avoid predictable mistakes, the industry can educate investors on common issues like confirmation bias – where people interpret events according to their own beliefs

Models on market volatility and returns suggest that investor panic can result in a loss of between 8 per cent and 15 per cent of assets over a 10-year period when portfolios are designed along risk capacity/preference lines.

By also incorporating behavioural tools, alongside traditional asset allocation, investors can receive a net increase of 17 per cent to 23 per cent in assets over 10 years. Some of that return comes from avoiding panic, supporting analyses by Vanguard and others.

The rest comes from freeing up asset allocation to better serve the financial needs of investors and removing the tension between the two competing demands: achieving an investor’s financial goals while avoiding uncomfortable volatility.

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Glenn Freeman is a senior editor at Morningstar.

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