CRA Roundtables – Recent Interpretations of Interest to Advisors
January 15, 2021
Show all

Battling Loss Aversion During the Market’s New Normal

(From the January 2021 Edition of eFORUM)

By Paul Orlander

2020 was a period of uncertainty, stress, and turbulence in our lives, and this has continued into 2021. COVID-19 has not only spurred self-isolation in our communities, it has also contributed to increased market volatility and economic concerns. Although we have experienced market downturns in the past, current anxiety about investing is different. It’s more emotional and there’s more at stake. Not only are investors concerned about their finances, they also have concerns about their family’s physical and mental health. Just like medical experts are helping us navigate the latest precautions and protocols, financial experts are offering advice and guidance for investors.

The arrival of COVID-19 in Canada brought one of the longest bull markets in history to an abrupt end in the first quarter of 2020. Sharp market declines occurred as pandemic panic took hold, raising investor anxiety and negatively impacting investor confidence and mindset.

Fear and the feeling of loss of control play havoc on investor behaviours. For some investors, volatile markets lead them to lose their long-term perspective and abandon well-thought-out plans. For investors, fear of loss can be disproportionate; that is, the prospect of losing money can have a larger impact on decision making than the prospect of making money. This phenomenon — loss aversion — was first described by economists Amos Tversky and Daniel Kahneman in the late 1970s but is still relevant today. Tversky and Kahneman suggested that individuals experience a loss twice as powerfully as a gain. More recently, research suggests loss can be felt even more powerfully. In some cases, people have a loss aversion ratio as high as five.

From a purely economic perspective, this is illogical. Should avoiding a $10 loss be considered five times more valuable than receiving a $10 gain? It shouldn’t, but emotions can impact judgment and lead us to make financial missteps. Investors may withdraw their money and sit on the sidelines — sometimes at the low point of the downward market cycle. The situation compounds itself when investors think they can time the market, believing they know the best moment to get back in. Another consequence is loss aversion may cause investors to invest too conservatively, in money market funds or guaranteed interested certificates (GICs) for instance, which may hinder their ability to reach their goals and may conceivably produce negative gains when adjusted for inflation.

Market volatility is likely here to stay for some time, and several geopolitical factors could upend the market recovery from the latter part of 2020. These include U.S.-China trade relations, the China-Hong Kong relationship, China-India tensions, Brexit-related risks, and threats to European Union solidarity. In the U.S., the transition to the new administration and its policies will be also be an important market driver.

A sustained low-interest-rate environment is also likely the new normal, leaving bond investors with dismal yields and low returns. Unprecedented levels of fiscal and monetary stimulus have helped buffer the global employment shock by subsidizing households and businesses, helping them through the worst of the crisis. But with mounting government debt, it’s unlikely we will see a rise in interest rates soon.

So how can advisors help calm their clients’ fears and help them to get better outcomes for the future?

Dr. Frank Murtha, a behavioural finance expert, recently shared the importance of three critical factors in helping clients avoid the consequences of behavioural decision-making:

  • a focus on long-term goals rather than market volatility;
  • re-establishment of the client’s sense of control; and
  • the presence of trust with the advisor and the quality of their advice.

In these turbulent times, it’s more critical than ever for clients to understand their risk tolerance, and to avail themselves of broad diversification. One significant trend we see is top advisors recommending diversified managed solutions to their clients. It’s not surprising given that investors are looking for growth but are wary of large swings in equity markets. This, coupled with low interest rates, also make risk managed solutions an attractive option.

Managed solutions that offer a globally diverse mix of investments and ongoing rebalancing are well suited for clients looking to manage overall portfolio volatility and deliver the right balance between growth and capital preservation. This balance can alleviate some of the stress clients may be facing in this volatile environment.

Some managed solutions utilize advanced portfolio construction and non-traditional strategies to further address volatility at the heart of many investors’ loss aversion. Alternative investments, such as collar strategies, help mitigate downside risk of equities. This is particularly important in managing sequencing risk, a critical factor for those nearing retirement.

We know that many Canadians have suffered financial hardship as a result of the pandemic, but we also know that Canadians are looking for advice and guidance on how they can continue to grow and manage their wealth for the long term. Having a sound investment plan will help investors focus on the long term in the face of short-term changes in the market.

Paul Orlander is the executive vice-president, individual customer, at Canada Life.

Join Advocis