Boxing clever with nudging isn’t about boxes at all

By Paul Nixon, Head of Behavioural Finance at Momentum Investments

With the COVID-19 pandemic in the rearview mirror there can be little doubt of the scars that remain, be it financial, societal, and psychological. As markets in South Africa tumbled in March of 2020 the behaviour tax soared. Anxious investors and advisers scrambled to get funds to what they perceived as “safety” and sat on the sidelines as markets recovered in a record time of three months.

The cost of this emotional comfort was severe. Investors in unit trusts lost a staggering 6.5% of their portfolio value on average in 2020. In our living annuity (the Retirement Income Option) the behaviour tax was equally alarming at just over 6%. This subsided in unit trusts slightly in 2021 to 3.5% but escalated in living annuities to over 4% in the same period. The pandemic has been replaced with geopolitical uncertainty, surging costs of living and rising cost of capital. The market turbulence trap is set and likely to ensnare many more advisers and clients alike. 

Using unsupervised machine learning algorithms, we were able to uncover four distinct and statistically significant behavioural patterns when analysing risk behaviour data from 2006 to 2021.

Without setting the behaviour tax (lower investment return from switching behaviour) as an explicit variable, the algorithm split the population into four groups with four very different behaviour tax levels. Said differently, each group was destroying value at different times which indicates that engaging with the right segment at the right time is important.

At the heart of this analysis was the understanding that we have long-term risk preferences (we like it or we don’t) but as markets ebb and flow we are drawn away from our long-term risk preferences as our perception of risk changes. Market crashes increase our perception of risk and even well-diversified investment portfolios start to feel like investing in much riskier investments. This is the illusion of the market turbulence trap.

Data science techniques like machine learning are particularly useful in finding behavioural patterns in large datasets. There is simplicity in patterns. However, four archetypes or boxes isn’t exactly personal (or at least not yet).

The problem with boxes and placing human beings in them is that the behavioural patterns that machine learning uncovers are based on average behaviour and can hide a lot of important detail.  

Take an extreme example. King Charles and Ozzy Osbourne are both male, born in 1948, raised in the United Kingdom, divorced and re-married, and both live in a castle and are wealthy and famous. But they are very different people. Some say talking about averages is just mean. Investors may be risk-seeking on average but that doesn’t mean there aren’t circumstances in which they also seek more emotional comfort because the context of a particular investment decision demands it.

How do we get closer to a behavioural fingerprint? We need to think more “human” by linking investor risk behaviour to psychological markers as well as attitudes towards money. “Personality” and “attitude” are often used interchangeably but there is a key difference. Personality is the set of characteristic behaviours that people identify as “you” and as such are more stable. An attitude can change, and the context of a money attitude will depend to a large extent on one’s experiences with money over our lives. Some use money to communicate status or prestige whereas others prefer the way money makes them feel.

With us, investing is personal and nothing is more personal than your personality. Understanding investor preferences psychometrically and cross-referencing observed behavioural patterns to strengthen the integrity of this gauge in the specific context of investing is powerful. Cross-referencing these insights with money attitudes and how markets may affect the perception of risk in the short term creates a behavioural fingerprint that powers rich advice conversations, more bespoke client engagement or nudges and a new world of hyper-personalisation for our advisers and their clients.

Just-in-time financial education subtly targeted at the investor’s behavioural fingerprint might just be enough to keep clients and advisers safe from the market turbulence trap.

If you want to read more about behaviour tax and how investors destroy wealth by switching funds, read our Sci-Fi report here or below, which provides a bird’s-eye view of investor behavioural patterns on the Momentum Wealth platform.

And for information on how to advise when the toast hits the floor jam side down… read our document on the principles of financial therapy to avoid the market turbulence trap here or below.

Momentum Wealth (Pty) Ltd (FSP 657) is an authorised financial services provider. Momentum Investments is part of Momentum Metropolitan Life Limited, an authorised financial services and registered credit provider (FSP 6406). The Retirement Income Option is a  life insurance product, underwritten by Momentum Metropolitan Life Limited, a licensed life insurer under the Insurance Act and administered by Momentum Wealth (Pty) Ltd. The information in this article is for general information purposes and not intended to be an invitation to invest, professional advice or financial services under the Financial Advisory and Intermediary Services Act, 2002. Momentum Investments does not make any express or implied warranty about the accuracy of the information herein.