Highly risk averse

A survey commissioned by Barclays Wealth, which covered more than 2,100 mass-affluent and high net worth individuals in more than 10 countries, reflects investors’ dilemma. Almost 88 per cent of those surveyed agree that the current markets offer significant investment opportunities, but as many as 68 per cent of them feel that the risk of further losses remains high. Only 28 per cent say that they plan to increase the level of risk in their portfolio over the next 12 months. Thus, while investors perceive opportunities in the markets, they are too petrified to take advantage of them.

Why the reluctance?

To explain investors’ behaviour, one will have to turn to the discipline of behavioural economics. In 1979, psychologists Daniel Kahneman and Amos Tversky suggested that the pain people feel when they sustain a loss surpasses the pleasure they feel when they make a gain of the same magnitude. It is estimated that the pain tends to be two-and-a-half times as intense as the pleasure.

Investors’ current loss aversion can also be explained by the fact that we humans don’t handle reversals in the direction of the market too well. As investors we tend to believe that the future will be a continuation of past trends.

It is this belief that engenders market booms. As markets rise and investors make money in them, their confidence level soars in tandem. They then begin to perceive lower risk in equities, even though a rational evaluation would suggest that as valuations rise higher the downside risk increases. What also comes into play is the phenomenon called the “house money effect”. Gamblers, after they have won some money in the initial rounds, are prepared to place bigger bets, their logic being that they are not betting their own money but what they have won at the table. A similar psychology operates in the markets, prompting investors to place riskier bets.

The opposite effect comes into play after investors have lost money. Their risk aversion rises much higher than usual. They then refuse to invest in opportunities which in the normal course of events they would have bet on willingly.

What has heightened the loss aversion further in the current crisis is the magnitude of losses that investors have suffered, and the duration for which the crisis has gone on.

Today, investors are like deers on a jungle road, frozen into inaction in the beam of a passing vehicle. As Richard Thaler and Cass Sunstein say in their book Nudge, “Loss aversion helps produce inertia, meaning a strong desire to stick with your current holdings.” This explains why the HNIs in the Barclays Wealth survey are unwilling to change their asset allocation in favour of riskier investment products even though they perceive opportunities. This inertia also manifests itself in investors’ reluctance to come to terms with their situation: book losses, or examine their portfolios to see exactly how much money they have lost.

Besides, at a time like this, before a decisive recovery gets underway, economic and financial data tends to send out conflicting signals. This adds to investors’ confusion and their unwillingness to take further risks.

The fallout

The financial losses and pain caused by the crisis have, however, had some positive effects as well, as the Barclays Wealth survey found. Respondents expressed a preference for simple and straightforward asset classes like cash, real estate, government bonds and domestic stocks. This can be explained by the fact that in times of crisis investors tend to find solace in the familiar. Besides, the widespread perception that the current crisis was triggered in the first place by complex financial instruments has added to the yearning for simplicity.

Respondents also say that they will exercise greater caution in the selection of financial products and service providers. Whereas earlier (during the boom) they would have gone with those who provided the highest returns, now investors say they will also take into account factors such as the transparency and quality of information provided, and how stable is the financial entity. Simple products, accompanied by literature that in simple language explains the risks and the fees charged, are likely to find more takers.

Chastened by their recent experiences, investors also say they will exercise greater due diligence before investing in a financial product, and will also spend more time analysing their portfolios.

A few negative fallouts are also evident. The preference for a high degree of cash holdings could affect future returns. The withdrawal by investors into domestic equities would reduce the level of diversification and could affect the returns they could have earned (from an internationally diversified portfolio).

Increasingly, what is dawning upon investors and investment advisers is that while valuations in the developed world might be attractive today, these nations offer limited scope for growth. Emerging markets are where investors will have to turn to for growth. This augurs well for a market like India.

What should you do

The Barclays Wealth survey is an international survey and it reflects the concerns of investors in the developed world, where the devastation has been much greater. Here in India the situation is not as dire. After performing poorly in 2008 and early 2009, the Sensex is up around 70 per cent from its February lows. As Satya Bansal, chief executive, Barclays Wealth, says: “Respondents from India have been more conservative than their counterparts abroad (see box) . Indian markets are being looked at very positively by foreign investors. Given that interest rates abroad are very low, foreign investors need destinations that offer good growth opportunities. So a lot of foreign investments should come into the Indian markets in future. Indian investors should not worry about FII outflows from the markets and should try to capitalise upon the opportunities available to them.”

The survey also has relevance for those investors who remain comatose after last year’s carnage. Says Pune based financial planner Veer Sardesai: “A lesson to draw is that since investors suffer a lot of pain when volatile assets like equities decline in value, they should limit their exposure to such assets to the level of pain and volatility they

can withstand.”

What is also called for is a return to rationality. Investors need to show decisiveness and must return to the basics. Poor-quality stocks, which were purchased during the boom (when anything you bought went up), should be winnowed from the portfolio. Investors must renew their search for stocks that are available at attractive valuations, whose businesses possess sustainable competitive advantage, and that are guided by management teams that possess both character and competence.

There is also a greater need to try and keep emotions out of the process of investing. As Sardesai says: “A good way to keep emotions out of the investment process is to enroll for the systematic investment plan of a mutual fund and thus automate the process of investing. The money gets drawn from your bank account regularly irrespective of the level of the market and your emotional state.” u

sk.singh@expressindia.com