Will the wealthy never learn about risk? A few months ago, Cambridge Associates LLC – the Boston-based investment firm with US$350-billion of assets under management – identified five “unexpected” scenarios investors should prepare for: “Correlations between asset classes during a sell-off . . . poor behavioural choices . . . a liquidity crunch . . . a lack of risk diversification . . . missing the opportunity to re-enter the market.”
Yet, anyone who remembers the global financial crisis of 2007-08 would surely not regard any of these as “unexpected” – and indeed would expect them to recur at some point. How, then, have clients’ memories and expectations become so fleeting?
According to one wealth manager, the American Dialect Society’s words of the year might help to explain. During the crisis, “subprime” and “bailout” were the epochal terms. By 2011, “FOMO,” or fear of missing out, almost took the award.
Even experienced, risk-conscious investors can succumb to financial FOMO: the fear of missing out on returns, which can overcome caution even with markets at all-time highs, according to Tiedemann Constantia AG, a multifamily office in Switzerland.
“As a bull market reaches maturity, investors can become victims of their environments,” explains Robert Weeber, Tiedemann Constantia’s chief executive officer. With each year of rising asset values, they suffer ever more “confirmation bias” – an overconfidence in their decision-making because recent results have been good.
Ed Raymond, head of portfolio management for Britain at Swiss bank Julius Baer Group AG agrees: “The longer the market rewards the investor, the less inclined they are to alter their behaviour, as the confirmation bias roots itself deeper and deeper.”
Nor is it in the interests of a sales-driven wealth-management industry to flag valuation risks.
“As a bull market enters thin air, the interests of investors and their bankers drift toward diametric opposition,” Mr. Weeber says. “At the moment when advisors should be stewarding clients toward restraint, they are often incentivized to do the opposite.”
Others take a more generous view and note that many financial advisors have no memory of losing out, making them just as susceptible to FOMO.
“About 60 to 80 per cent of the financial industry is renewed every cycle, so institutional learning fades,” points out George Lagarias, chief economist at advisory group Mazars in London. “Even the older operatives after a long time of low risk will be hard-pressed to believe ‘now is the time to panic’.”
He’s not alone in thinking some professionals are now risk immune. Alexandre Tavazzi, global strategist at Pictet Wealth Management, notes that “depending on when your career started, you may have never been exposed to a long-term period of a rising cost of capital or long-lasting bear market.”
Risk has been further pushed to the back of investors’ and advisors’ minds by central bank stimulus, not least the U.S. Federal Reserve Board’s low-interest rate policy.
“Complacency comes from the fact that risks are now perceived as being managed by the Fed,” argues Didier Saint-Georges, managing director at asset manager Carmignac Risk Managers in Paris. “Being risk averse is tantamount to betting against the Fed, which is not an easy option.”
What’s easy, reckons John Veale, deputy head of investments at multifamily office Stonehage Fleming in London, is buying into the Fed’s narrative: “Monetary policy has changed so dramatically since the [global financial crisis], impacting correlations between asset classes and making it easier to believe ‘this time it’s different’.”
If anything, though, this just creates another risk, Mr. Lagarias says. He admits central bank policies have been successful in “actively suppressing risk” but fears this cannot last. “The real risk is in that suppression stopping, or markets losing faith in the abilities of central bankers to mitigate risks.”
Or perhaps it lies in markets gaining a belief that cheap money has pushed prices too high. To Mr. Tavazzi, “a world in which central banks keep the cost of funding low for everyone and subsidize market stability is by definition a fragile one . . . market risk has risen considerably as many financial assets have reached very high valuations”.
That makes old assumptions about certain asset classes being uncorrelated to each other quite dangerous, he says. “The supposed ‘natural hedge’ may amplify portfolio losses instead of protecting it.”
The final word on why investors never seem to learn about risk comes not from recent history but prehistory.
“Most investors, companies and even governments have over 10 years adapted very well to an environment of slow but positive economic growth, with ample liquidity and very low interest rates,” says Mr. Saint-Georges. “They are like dinosaurs, perfectly adapted to their environment . . . so much so that, the day the environment changes, many might find it extremely difficult to survive.”
Investors must therefore hope their advisors alert them to historical threats they have ceased to expect.
“They need to be educators,” says Mr. Weeber. “The risk discussion should be taking place constantly throughout the market cycle.”
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