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ensure we have the financial solvency to stay invested in bad times, and the emotional solvency to stick with our investments (and not jump ship at the bottom). Both may involve sacrificing some long-term gains to ensure we have adequate reserves (of liquidity and composure) to see us through good times and bad.

This is not just an abstract point: financial decision- making strategies are at least as important to long-term performance as the assets we actually invest in. Recent research we sponsored from Cass Business School shows that investment timing decisions by retail investors, with regard to equity mutual funds, reduced their returns by an average of 1.2% per year. This might not sound like much, but when you consider that a typical diversified portfolio for a moderately risk-tolerant investor will earn approximately 4% more on average over the long term than holding cash, it becomes clear that the average investor is giving away more than a quarter of the expected upside of investing at all. This investor behaviour penalty equates to a compounded 20% over the 18 years under analysis, before transaction costs. And this is the average – some investors fare far worse!

In December 2006 Barclays Wealth set up a team of behavioural specialists that is unique in the industry. Since then, they have been designing and implementing tools to help investors avoid this ‘behavioural penalty’ by deploying the power of the many insights to be derived from behavioural finance. The first of these was the Financial Personality Assessment – this was designed using data from around 6,000 experimental subjects worldwide and has now been used by nearly 12,000 clients and prospects around the world. It provides a robust assessment of each individual’s financial personality on 6 different dimensions, which allows us to be far more accurate in tailoring a portfolio to client’s needs, both financial and emotional. In particular, our measure of Composure, the degree of emotional engagement with short-term investment outcomes, is an essential supplement to traditional risk tolerance when trying to help investors overcome the investor behaviour penalty.

Beware the Sirens’ song

Sadly though, merely telling people about their possible tendency to react less than rationally in times of future stress has again and again proved insufficient to build up the well of psychological liquidity they’ll need to see them through times of great ebullience or fear in the markets. We have to do more than talk: we need to change the portfolio solutions we give clients and set up decision-making structures in times of calm, to prepare them for times of market stress.

This is an age old problem which Homer alluded to in the Odyssey. As Ulysses sails home past the island of the Sirens, he is warned that he and the crew will be unable to resist the temptation of the Sirens’ song. Their resolve to do the right thing will be completely overcome by the momentary beauty of the song and they will sail to their deaths on the rocks.


// Ulysses and the Sirens by John William Waterhouse, 1849-1917

As with investing, the rational response to this danger is not hidden, it’s just psychologically very difficult to manage. Odysseus was aware of his own fallibility and knew he would not be able to resist the Sirens’ song. So before they could be tempted by the song he ordered his crew to bind him to the mast with ropes and to stop up their ears with beeswax. And thus they sailed past safely.

Whilst completely binding your own future investing options may be an extreme method, certainly there are many similar pre-commitment strategies that can be employed to help control the emotional and behavioural responses that can harm your financial performance. Knowing your own financial personality is the first step, but it’s what you do with this information in times of calm that will determine your success.

//…develop the reservoir of psychological resilience needed to avoid the natural

tendency to buy high, sell low.

At Barclays Wealth we embed the results of our Financial Personality Assessment throughout our investment philosophy, in how we build a portfolio recommendation, in our product selection, in our process and systems. The low composure client will have greater need of strategies to control their future behaviour than the high composure client. So, while we don’t provide our clients with beeswax, through a combination of in-depth knowledge of each client and a range of products and portfolio solutions, we can help ensure that our clients not only have a portfolio that is rationally right for them but one with which they are also emotionally comfortable. Thus they develop the reservoir of psychological resilience needed to avoid the natural tendency to buy high, sell low.

Source: Greg Davies is Head of Behavioural and Quantitative Finance at Barclays Wealth

// JULY/AUGUST 2011 39

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