Natural human emotions can lead to poor financial decision-making during the cut and thrust of the market cycle. To mitigate that risk, following an investment plan based on a robust framework is crucial, says Philip Legrand (pictured), Client Advisor at UBS in Jersey
We’ve all heard the age-old cliché that we should ‘buy low and sell high’, but humans are emotional beings. We tend to be underwhelmed by successes and magnify our losses. Investors are no stranger to this behavioural bias. Therefore, it is likely to be a case of ‘buy pretty high and sell lower when fear takes hold’.
Many investors tend to make their costliest errors during transition points in the market cycle. There is nothing particularly abnormal about this behaviour, but it can pay dividends to avoid it at all costs and take a longer-term view on your wealth.
One way to help investors navigate tricky times in markets is to have a plan in place and – more importantly – to stick to it. At UBS, we see the latter stage of an economic cycle as the best time to lay the foundations of your financial plan – before the next downturn.
Our Liquidity, Longevity, Legacy (3L) approach to wealth management can help you plan for your long-term goals while reducing the danger of falling prey to costly decisions during downturns. The 3L framework allocates your wealth into three strategies:
1. Liquidity – A Liquidity strategy is designed to fund expenditures and meet liabilities for the next two to five years. Investments should be held in safe assets with low volatility, typically cash, and/or a high-quality bond.
2. Longevity – A Longevity strategy helps you meet your financial goals for the balance of your lifetime and is characteristically well diversified across asset classes with a growth orientation. The exact composition of the portfolio depends on your situation, financial goals, personality and values.
3. Legacy – A Legacy strategy includes assets that are in excess of what the family members need to meet their own lifetime objectives. Generally, investors slowly spend down their longevity assets during retirement. At the same time, legacy assets are generally unencumbered so they can appreciate in value.
How the 3L framework can help investors navigate bear markets
Most investors loathe equity bear markets. However, for those who are still accumulating assets, they can actually represent important opportunities to invest in growth at a lower price.
As a result, if managed properly, market downturns (though emotionally difficult) can increase long-term wealth. With the equity bull market ageing, now is a good time to consider sufficient liquidity requirements in order to avoid being forced to sell assets at depressed levels when the next bear market finally arrives.
The 3L approach can help mitigate such ‘sequence risk’. It enables investors to spend out of their Liquidity strategy during drawdowns. By doing so, they give risk assets in their Longevity strategy time to recover before having to sell them for spending needs.
This was illustrated most clearly during the tech crash around 2000. Consider investors who wanted to spend 4% of their initial wealth annually in retirement. If they began filling their Liquidity strategy in 1999 before retiring in 2002, then spent out of their Liquidity strategy and only refilled it once the Longevity strategy’s portfolio recovered from the drawdown, by 2017 they are likely to have had 4% more wealth than if they had spent directly out of their portfolio.
Resisting market timing with the 3L framework
Aside from forced selling, the turn of a market cycle can also be problematic due to the temptation to make significant changes to your portfolio at the wrong time.
In Trading is Hazardous to your Wealth, Brad Barber and Terrance Odean indicate that households with the highest portfolio turnover underperformed average investors by 5% per year and trailed low-turnover investors by almost 7%.
One way of minimising risk related to costly emotional behaviour is to establish a disciplined investment approach, such as rebalancing.
Selling top-performing asset classes and buying worse-performing asset classes can be counterintuitive, but our analysis shows establishing a disciplined rebalancing approach within the 3L framework can add 0.8% alpha (the excess return of an investment relative to the return of a benchmark index) annually.
The 3L framework may not be a panacea for solving our own emotional biases, but it can provide a framework for decision-making that investors can fall back on during times of market stress.
Investors are more likely to think twice about selling assets associated with long-term objectives. By embedding major financial decisions in specific financial goals and objectives, the framework provides guidance for action during difficult periods.
Have a plan and stick to it
Nobody is perfect. The next time news reports detail a possible downturn, no matter how big or small, be sure that personal psychological biases will play tricks. Having a plan and sticking to it can be the difference between compound growth and cashing out when your portfolio is performing poorly, then having to buy in at a higher price.
FIND OUT MORE
If you would like more information on how UBS Wealth Management in Jersey can provide support, please contact Philip Legrand:
Philip Legrand, Client Advisor UBS AG Jersey Branch
1, IFC, St Helier, Jersey JE2 3BX
Tel: 01534 701180
Email: philip.legrand@ubs.com
© UBS AG, Jersey Branch is authorised and regulated by the Jersey Financial Services Commission for the conduct of banking, funds and investment business. UBS AG, Jersey Branch is a branch of UBS AG (a public company limited by shares, incorporated in Switzerland whose registered offices are at Aeschenvorstadt 1, CH-4051, Basel and Bahnhofstrasse 45, CH-8001 Zurich) with its principal place of business at 1, IFC, St Helier, Jersey JE2 3BX. Terms and Conditions are available upon request. © UBS 2020. All rights reserved. www.ubs.com/jersey
• This advertising feature was first published in the February/March2020 edition of Businesslife magazine