The Business Times, Friday 9 July, 2004

Mitigating emotional decisions

On-going financial advice can help deter investors from irrational behaviour, says JOSEPH CHONG

THE past 18 months have seen dramatic turns in equity and bond markets. Deflationary concerns, Sars and wars pushed global equity markets to five-year lows and government bond yields to multi-decade lows in 2003. The media were full of doomsday talk and the investing public were fearful. As advisers, we were not without concern as historically markets which have become very cheap can often become even cheaper.

This notwithstanding, we recommended buying the equity markets in an article in BT on May 14 last year, in the midst of Sars and other end-of-the-world expectations. Many clients then agreed with us but many chose to act only partially as they were terrified. This is fine as they benefited but not necessarily 100 per cent.

Indeed, the value of on-going advice is to mitigate the effects of investor emotion on decision-making - avoiding selling in desperation at market bottoms and mortgaging the home at tops. Perfect implementation is rarely possible as greed and fear are intrinsic to our human genetic configuration.

For many of us who provide on-going advice to clients, it was heart-warming to hear the Monetary Authority of Singapore recently say that it would like to see compensation tied to on-going advice, instead of sales volume. Indeed, this was incorporated into its consultation paper last month on switching, which is currently available on the MAS website.

On-going advice is often structured within so-called wrap or managed accounts. These are essentially investment accounts where the on-going compensation of the adviser is tied to the value of the assets in the account. The on-going advisory nature of such accounts demands of the financial adviser continuous concentration, care and compliance - much harder work than one-off sales. An informative article on such accounts was written by Genevieve Cua and published in BT on June 16.

Psychological barrier

Just like any other product or service, wrap accounts are not for everyone. Someone who is trained and experienced in investment management and who dedicates several hours a day to reading the relevant business literature would not need on-going advice. These would typically be retirees who have been successful in managing their money and investment professionals who leverage their work expertise into their personal portfolios. However, this would be the minority among the investing public.

Most would benefit from having some of their portfolios come under on-going advice. This is because successful investing is a function of continual insight, which can only be arrived at through labour-intensive analysis of incoming data.

The barrier for the non-professional investor is physical as even the best fund managers who are already attuned to reading charts, graphs and economic reports rapidly spend many hours a day reading. As in school, the kid who spends the most time swotting usually comes out tops.

The other serious barrier is psychological. People fall in love with their investments or have an irrational dislike for some. The on-going advice from a professional investment adviser is less likely to be so as he is unlikely to be emotional about money which is not his. This would be analogous to doctors finding it difficult to operate on close relatives.

Active advice and indexing are not mutually exclusive. Indeed, in the model portfolios which we advise clients on, up to 50 per cent are in a variety of indexed funds. For global asset allocators like us, index funds are useful as they ensure that certain market bets would be 100 per cent invested - particularly useful for buying market bottoms. We believe globally diversified portfolios offer the best risk-reward payoff.

However, the country and sector components of such portfolios are seldom correctly priced relative to one another at any one time. This is because of 'economic friction' between different stock markets.

Economic and political barriers often prevent valuation equilibrium from being achieved. For example, most pension and insurance funds require that the investments remain largely in-country, even if the country's stock market is grossly overvalued. However, even if these barriers are removed, investors are unlikely to allocate on a more global basis. For example, only about 15 per cent of mutual fund assets are diversified out of the US, compared to about 50 per cent of the MSCI World equity index being non-US. The barrier is psychological as most people believe it is safer to invest closest to home.

It is important when choosing a wrap account to consider not only the quality of the advice that comes with it but also the fee structure. It is important here to look beyond advertised low headline numbers: