Morningstar conference update: Behavioural specialist explains why simple is best for investors

(May 6, 2004) Ena Garmaise has spent a good many years trying to perfect a fear barometer for Canadian investors. She wouldn’t call it that because there is nothing sci-fi about her work in behavioural finance or in the detailed questionnaires she designs for advisors.

What she’s actually doing is giving advisors a tool to read their client’s true risk tolerance, something unseen and often misjudged by the clients themselves.

Garmaise presented some of her findings at Morningstar Canada’s investment conference in Toronto on Wednesday, May 5. In her talk, Garmaise discussed how misleading clients’ answers to direct questions about risk can be and how misaligned investors’ goals can be relative to their risk-taking attitude. She also shared some stimulating findings about people’s reaction to choice and decisions that should encourage every advisor to keep things simple.

“Risk takers often don’t perceive themselves as risk takers and people who are risk averse are so risk averse that they think they are taking more risk than they actually are,” said Garmaise. “People’s benchmarks are very personal… and part of what you can do for them is to understand what their benchmarks are.” Part of this is reconciling clients’ risk tolerance with their investment goals, according to Garmaise.

The speaker noted that 50% to 60% of investors have “investment goals that are not consistent with their risk attitudes.” Even more unnerving, one in 10 investors is seriously misaligned, said Garmaise, adding that these investors think they have conservative goals but can actually sustain a long-term growth portfolio, or think they have aggressive goals when their risk tolerance would be met with a conservative portfolio.

Asking clients about their investment horizon is similarly unenlightening. Most people will answer that they have an investment horizon of around 10 years, Garmaise noted.

Garmaise believes it is much more useful to ask investors how long they will take to decide if their investment strategy is satisfactory. Sixty-five per cent of investors with the goal of preserving their capital will give their strategy less than two years, while 55% of long-term growth investors will do the same. “This is a strong indication that many long-term growth investors are unlikely to stay the course beyond two years,” concluded Garmaise. “They want long-term growth every day.”

The behavioural specialist also had some arresting findings about decision making. She related a study in which a table with gourmet jams was set up in a grocery store. On one day, six jams would be displayed. On alternate days, 24 jams would be displayed.

More people visited the table with 24 jams, confirming our belief that choice is a good thing; however, 30% of the people who visited the six-jam table bought something. Only 3% of visitors selected from among the 24 jams. Furthermore, those that bought from the smaller selection reported higher satisfaction with their purchase than those who bought one of the 24.

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Garmaise’s conclusion? Choice is good, but requiring too many decisions is bad.

A 1997 paper she cited compared investors’ choices in an intense investing environment to those in a low-key investing environment. The intense environment had lots of choice, plenty of information and required many immediate decisions. The low-key environment didn’t permit any immediate decisions.

If you need your clients to endorse a higher risk strategy, pay attention to this: 70% from the low-key environment invested in higher risk assets. Only 45% from the intense environment did so.

Garmaise went on to point out that risk preferences and goals are not static — they are affected by market activity, and perhaps, their advisors’ counsel. As Garmaise concluded, “The financial planning process is a dynamic one and you end up changing your clients, too. An investor profile elicits preferences and shapes them, too. Work with human nature.”

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Ena Garmaise is vice-president, product research, for LOGIX Asset Management Inc., a Toronto-based firm she and her husband, Gordon Garmaise, established in 2003 as part of Garmaise Investment Technologies Inc., the company that designed and ran Mackenzie’s Star program for nearly nine years and its Keystone program for over six years. LOGIX designs personalized, risk-adjusted portfolios of third-party funds for clients of advisors in Ontario, Alberta and British Columbia.

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Donna Green, MA, CFP, is a personal finance writer and assistant author of The New Investment Frontier: A Guide to Exchange Traded Funds for Canadians, and Surprise! You’re Wealthy: A Woman’s Guide to Protecting Her Wealth.

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(05/06/04)