Traditional finance assumes investors, after they do sufficient research, will make rational decisions.
But a new report by Wells Fargo Investment Institute — Balancing Risk and Reward: Choosing the Right Mix for Your Portfolio (PDF) — suggests that emotions also influence investors.
According to a hypothetical example in the report, chasing past winners isn’t a successful strategy. If an individual invested all of their money in the top-performing asset class from the prior year, their investment would have lower returns than a portfolio based on a moderate growth and income allocation in each of the last 15 years.
“This kind of decision-making is just one example of an unsuccessful investing strategy,” said report co-author Tracie McMillion, head of Global Asset Allocation for Wells Fargo Investment Institute. “Biases including being overconfident or delaying decisions out of fear of making mistakes can be hard to overcome.”
Psychology of investing
The Wells Fargo Investment Institute report comes at a time when the field of “behavioral finance” is continuing to evolve, and researchers continue to explore the reasons why investors deviate from rational decision-making.
Michael Taylor, investment strategy analyst for Wells Fargo Investment Institute and report co-author, said investor biases are at the root of irrational decisions and can affect investment choices and portfolio returns. Some of these biases include:
- Being overconfident, or believing your judgment is better than it is, which can lead to underestimating risk and overestimating returns.
- Being resistant to change and failing to make portfolio changes.
- Strongly avoiding losses at the expense of achieving gains, resulting in holding on to losing assets too long or letting go of winning assets too soon.
- Being afraid of making mistakes, resulting in holding a very conservative portfolio.
Defining your risk tolerance
To help thwart rash decisions, McMillion recommends that investors start with the basics: determining their investment goals, time horizon and risk tolerance. She said asking questions like “How much risk am I comfortable taking?” or “Are my expectations for portfolio returns realistic?” can help investors set their longer-term investment plan and maintain a broadly diversified portfolio with a level of expected risk that aligns with an investor’s return objectives.
Then, McMillion said, when investors face unexpected market movements — like the recent 1,000-point swings in the U.S. equity markets — they won’t be tempted to abandon their investment strategies and make changes to their investments based purely on emotions.
Determining your approach
Taylor outlined two investment approaches that acknowledge investor biases and help manage them to balance risk with reward within portfolios.
- Behavioral life-cycle model: Moving assets into separate investment accounts for spending and saving to meet both short-term needs and long-term goals. This approach emphasizes self-control and accounting of current income, current assets, and future income.
- Behavioral portfolio theory: Constructing portfolios in layers to meet specific investor goals, such as financing college for children. The most conservative layer is at the bottom, and reflects needs like housing and food, and the highest layer reflects far-reaching goals with greater risks — perhaps purchasing an expensive vacation home. Behavioral portfolio theory allows an investor to remain risk averse while also take some risks.
Taylor said both approaches allow investors to acknowledge and include their emotional considerations while managing risk.
“Adding in a qualitative, behavioral component when initially constructing a portfolio might be an option that investors should consider to better limit the potential negative impact of biases,” he said, adding that this strategy might also help investors remain committed to long-term objectives.
When it comes to balancing risk with reward, Taylor said the investment fundamental of diversification remains an important principle since it can help reduce specific asset risks while realizing potential rewards.
“Overall,” he said, “building a diversified portfolio — such as a mix of global equities, global fixed income, real estate investment trusts, commodities, and hedge funds — can help investors achieve better returns over a full market cycle, when adjusted for risk.”
Risk Factors All investing involves risk including the possible loss of principal. There is no assurance any investment strategy will be successful or that a fund will meet its investment objectives. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Alternative investments carry specific investor qualifications which can include high income and net-worth requirements as well as relatively high investment minimums. They are complex investment vehicles which generally have high costs and substantial risks. The high expenses often associated with these investments must be offset by trading profits and other income. They tend to be more volatile than other types of investments and present an increased risk of investment loss. There may also be a lack of transparency as to the underlying assets. Other risks may apply as well, depending on the specific investment product. Exposure to the commodities markets may subject an investment to greater share price volatility than an investment in traditional equity or debt securities. Investments in commodities may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity. Products that invest in commodities may employ more complex strategies which may expose investors to additional risks. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. Investments in fixed-income securities are subject to interest rate, credit/default, liquidity, inflation and other risks. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline in the bond’s price. Credit risk is the risk that an issuer will default on payments of interest and principal. This risk is higher when investing in high yield bonds, also known as junk bonds, which have lower ratings and are subject to greater volatility. If sold prior to maturity, fixed income securities are subject to market risk. All fixed income investments may be worth less than their original cost upon redemption or maturity. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets. There are special risks associated with an investment in real estate, including the possible illiquidity of the underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. General Disclosure Wells Fargo Investment Institute, Inc. (“WFII”) is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company. The information in this report was prepared by WFII. Opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.