Financial Times: Overconfident investors need diligent advisers who can alert them to threats

March 6, 2020

By Matthew Vincent

Will the wealthy never learn about risk? A few months ago, Cambridge Associates — the investment firm with $350bn 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 2007-08 financial crisis 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, nearly took the award. And, says multifamily office Tiedemann Constantia, 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.

“As a bull market reaches maturity, investors can become victims of their environments,” explains Robert Weeber, Tiedemann Constantia chief executive. 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 the UK at Swiss bank Julius Baer 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,” he says.

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,” says Weeber. “At the moment when advisers should be stewarding clients toward restraint, they are often incentivised to do the opposite.”

Others take a more generous view and note that many advisers have no memory of losing out, making them just as susceptible to fomo. “About 60-80 per cent of the financial industry is renewed every cycle, so institutional learning fades,” points out George Lagarias, chief economist at advisory group Mazars. “Even the older operatives after a long time of low risk will be hard-pressed to believe ‘now is the time to panic’.” He is 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 advisers’ minds by central bank stimulus, not least the US Federal Reserve’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. “Being risk averse is tantamount to betting against the Fed, which is not an easy option.” What is easy, reckons John Veale, deputy head of investments at family office Stonehage Fleming, is buying into the Fed 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, 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 Tavazzi, “a world where central banks keep the cost of funding low for everyone and subsidise 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 feels. “The supposed ‘natural hedge’ may amplify portfolio losses instead of protecting it,” he says.

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 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 advisers alert them to historical threats they have ceased to expect. “They need to be educators,” says Weeber. “The risk discussion should be taking place constantly throughout the market cycle.”

Read article on Financial Times here.

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