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The emotional influence on investing is overwhelming for the vast majority of people. It’s even more challenging for balanced portfolios today with yields being so low.

gopixa/iStockPhoto / Getty Images

Financial advisors are no strangers to Harry Markowitz and his Nobel Prize-winning modern portfolio theory, which advocates for diversification to maximize returns at a manageable level of risk. But did you know he couldn’t fully apply his breakthrough theory to his own portfolio?

As an advisor, you go through a ‘know-your-client’ (KYC) exercise when you first meet your clients and then annually to gauge their risk profiles. But is that enough? Do you need to dig further into their psyche to gain a greater understanding of their tolerance for risk?

We spoke with Larry Berman, co-founder, chief investment officer and portfolio manager at ETF Capital Management in Toronto recently to discuss these issues. Here is an edited and condensed version of the interview:

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What do you think about Mr. Markowitz having taken less risk in his own portfolio than his theory suggested he should?

He’s human. The emotional influence on investing is overwhelming for the vast majority of people – even Nobel Prize winners. In fact, it’s even more challenging for balanced portfolios today with yields being so low and the entire world of debt that offers a negative real return.

Everyone should have 100 per cent exposure to the highest long-term expected return asset class and never look at the value of their portfolio. But the human condition simply will not allow it. They should also have a portion of safe liquid, cash-like holdings to meet known shorter-term needs.

The low-yield environment will be with us for a long time, and it’s a huge problem. This was not Mr. Markowitz’s problem; he got a good return from bonds over the years. But the best of that theory is now in the rear-view mirror. His problem was risk aversion. Everyone is different in this regard and we’re not perfect economic actors. The whole area of behavioural finance has revealed these facts over the years.

How often do you see this with your clients?

We spend a lot of time and effort educating people about the influence of behaviour. One of the most recent emotions among investors is fear of missing out. That’s the opposite of what Markowitz demonstrated. The behavioural influence is your biggest cost of investing – by far. It promotes selling when you should be buying and buying when you should be selling. Timing markets is difficult. The data are overwhelming that the emotional cost of investing is massive and hurts the average investor. Everyone has these issues. Even me. We just need to recognize that emotions are driving the decision-making – not rational, cognitive, long-term behaviour.

Do you see risk challenges that differ for high net-worth investors versus the average investors? In other words, does greater wealth mean taking on less risk, generally?

The KYC evaluation is partly a means test, too. If you start with $10-million and end with $7-million, you may be upset, but your standard of living won’t change much. But if you have $3-million and end up with zero, it’s the same dollar loss, but you’re wiped out.

Psychologists Daniel Kahneman and Amos Tversky* won a Nobel prize in 2002 for their work on prospect theory: The understanding that people dislike losses about double the rate of a similar dollar gain. Richard Thaler and others have added to this thinking.

Larry Berman, co-founder, chief investment officer and portfolio manager at ETF Capital Management in Toronto.

The emotional response to seeing the value of your savings go up and down explain the fear and greed aspect of market cycles. People are greedy and complacent when markets are rising and experience panic and despair when markets are declining. That promotes a “buy high” and “sell low” response that’s the exact opposite of what investors should do. It doesn’t matter how much you have, it hits everyone. Having better means just gives you more options. Wealthier investors can afford more sophisticated, uncorrelated approaches that can help to mitigate the negative emotional feedback loop.

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What could this risk aversion cost the average investor?

There are well-documented studies that show the emotional cost of investing can be as much as 500 basis points (or 5 percentage points) per year, on average.

U.S. research company DALBAR Inc. produces the average realized return of mutual fund holders annually by looking at all the buy and sell tickets and calculating the money-weighted return. [Investor behaviour is] the biggest cost, by far, and outweighs management fees, trading fees or advisor compensation.

Mr. Markowitz knows this and yet he cannot help himself. The average investor doesn’t stand a chance.

*Note: Mr. Taversky was awarded the Nobel Prize posthumously.

Kelley Keehn is a personal finance educator, author and FP Canada’s consumer advocate. She is also a former advisor.

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