How to overcome the psychological biases that threaten true diversification
Everybody knows the importance of diversification, yet your clients might be unaware of the psychological problems they may have to overcome to build a well-diversified portfolio. That’s according to Greg Davies, an expert in investor psychology and Head of Behavioural Finance at the behavioural fintech Oxford Risk, who recently spoke to Aviva.
As Greg says, diversification is critical to ensuring a portfolio can grow in a balanced manner over time while also being protected from turbulence in financial markets “because any one thing you invest in can go to zero forever”.
You might think ensuring your clients have exposure to a wide range of assets and geographic markets is easy. Not so, says Greg, who argues that, unfortunately, investors – like all humans – are prone to inbuilt biases.
One problem, for example, is that instead of buying a diversified portfolio of good investments, many people will construct a highly concentrated portfolio of good stories.
“They might have 20% of their wealth in a particular stock because a friend works there and says it is a great company. Or they own a mobile phone, like the product and tell themselves the company must be a good investment”, says Greg.
He also points out that we are all subject to a concept known as “confirmation bias”, which is our tendency to interpret new evidence as confirmation of our existing beliefs or theories. So, if an investor decides that an investment is a good one, they are likely to look for evidence to support that view, filtering out evidence that would prove them wrong.
Greg explains: “We like to think that we make up our minds by looking at the evidence and coming to a rational conclusion. But psychological research has shown that, much of the time, the opposite is true. We decide what we want to believe and go looking for the evidence to corroborate that view.”
How to overcome the psychological pressures facing investors
Professional investors, of course, are subject to the same human prejudices as everybody else. But they operate in a highly structured environment and are subject to risk controls and disciplined investment processes. They also work as part of a team. Investment ideas, for example, are thoroughly researched by analysts and hotly debated before being included in a portfolio. Moreover, the investment team in a company such as Aviva Investors can draw upon a huge range of resources, including investment specialists across all asset classes and geographic markets, as well as professional economists and a huge range of data.
All of these factors mean that the best way of overcoming the inbuilt biases we are all subject to is to invest in highly diversified, professionally managed portfolios such as the Aviva Investors Multi Asset Funds (MAF) and the Smooth Managed Fund range.
These fund ranges provide a simple way to grow your clients’ savings. They offer exposure to a broad range of assets, which, when combined, aim to manage risk and deliver long-term growth for clients. The funds in both ranges can also be matched to your client’s particular level of risk appetite. The Smooth Managed Fund range, for example, offers a low- to medium-risk fund plus a medium-risk portfolio.
Meanwhile, the Aviva Investors Multi Asset Funds are composed of ten different portfolios; MAF Core (Passive focus) and MAF Plus (Active focus) which consists of 5 funds in each range, ranging from the lowest risk, which tends to be characterised by relatively low volatility and low growth potential, to the highest risk, which has greater potential to deliver growth but may also be subject to greater volatility.
Critically, the fund ranges use an asset-allocation model to blend asset classes for diversification. In other words, the asset-allocation model determines, within a range, the fund’s allocation to the different asset classes. That means that all of the psychological biases described by Greg earlier in the article cannot play a role in the construction of these portfolios!
The value of an investment can go down as well as up. The return at the end of the investment period is not guaranteed and your client may get back less than they originally invested.