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Managing “emotional returns” in investments is key to staying on track

Let’s examine the recent performance of a couple of different asset classes in recent times to demonstrate the importance of managing emotional returns in investments…

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International Investor, Here’s the easiest way to invest in your future 

In our 2019 outlook, one of the key messages that we have constantly communicated over the years is the importance of diversification. While we get the sense that some of our investors have been heeding this message, it is also clear that some are yet to be convinced.

This year, in conversations with some clients, we introduced the idea of “emotional” investment returns, highlighting that the way you implement diversification can have an impact on how your investment returns affect you. This can, in turn, impact your future investment decisions which could be detrimental to your long term financial returns. This idea clearly resonated with them and we decided to share it more broadly.

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One of my favourite books is Daniel Kahneman’s Thinking Fast and Slow. Kahneman is a Nobel prize winner for his research (with Amos Tversky) into behavioural biases. One of their theories is “prospect theory”, which states that “the pain of losing is 2 times greater than the pleasure of winning”.

Let’s examine the recent performance of a couple of different asset classes in recent times to demonstrate the importance of this finding.

One of the most popular asset classes in 2018 was US equities, which rose 11.2% from its start of the year level of 5212 to its 5794 peak-level in September, before falling 14.0% from the peak to its year-end level of 4984. From a “classic financial” point of view, if this was the person’s only investment (let us say USD 10,000), the loss would have been 4.4%. Not ideal, but hardly the end of the world. However, from an “emotional” point of view it was probably a lot worse.

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[Read Also: How to use profits to determine what stock to buy]

Taking Kahneman’s 2:1 emotional cost/benefit ratio into account, the investor would have experienced 11.2 gain in ‘emotional points’ followed by a 28 points loss (2 multiply by 14), before arriving at a net loss of 8.8 “emotional points”. What an emotional roller coaster!

But what about an investor who got intrigued by our call for diversification?

There are two potential ways to achieve this. One way is to invest equally in two different funds. The second is to invest in a fund that has a 50:50 split between the two asset classes. While they are financially equivalent (assuming the fund manager invests in the same underlying assets), emotionally they can be very different.

To work fully, financially as well as emotionally, diversification requires investors to look at their investments as a pool and not as a set of separate items. Another Nobel prize winner, Richard Thaler, established that many of us have a tendency called “mental accounting” that often prevent us from looking at things in totality. What this means is we all have the tendency to look at each individual line of an investment portfolio. This can influence us to make sub-optimal decisions.

Developing the above analysis further, let’s take the example of an investor who decided to split her US equity investment, allocating USD 5,000 to global bonds. On this second investment, she would have made a loss of 1.9% (loss of 3.8 “emotional points”) through to the peak in the US stock market and then a gain of 0.7% (gain of 0.7 “emotional points”) in the remainder of the year for a net loss of 2.4 “emotional points” over the year.

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The combination of the two investments would have been a 4.6% gain through to the peak in the US stock market and then a loss of 7.1% in the remainder of the year for a net loss of 2.8% over the year. But “mental accounting” would have prevented our investor from aggregating ‘emotional’ returns, the equity allocation remaining a painful 8.8 “emotional points” loss.

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[Read Also: How a Nigerian can invest on Singapore Stock Exchange]

However, for the investor who decided to invest USD 10,000 in one fund that diversified across both US equities and global bonds, her return would have been 4.6% (4.6 “emotional points”) through September and then a loss of 7.1% (-14.2 “emotional points”) in the remainder of the year for a net -5.6 “emotional points” loss.

As you can see, the financial return is clearly the same at each point, but the ‘emotional’ returns can be very different if the investor mentally accounts for each individual investment.

When using a balanced product, the reduction in the ‘emotional’ pain during the equity market fall (-14.2 points vs -28 points) far outweighs the loss of ‘emotional’ gain up to the peak period (4.6 points vs 11.2 points).

The risk of ignoring the investor’s ‘emotional’ pain would be so great that they would sell what is hurting them. Not only could this distract them from their long-term objectives, but in this instance, it would also have meant selling equities just before the strong rally we subsequently saw since the turn of the year (+11.8%).

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Helping our clients make less biased investment decisions is one of our key objectives at Standard Chartered Bank. The above academic research, together with our day-to-day experience with clients, suggests investors should allocate a significant portion of their investments to core diversified holdings as we believe this will help them manage their emotions and stay on track when it comes to their long-term financial goals.

Alexis Calla is Chief Investment Officer at Standard Chartered Bank

Nairametrics frequently publishes articles from experts such as financial analysts, economists, researchers and investors. We also feature articles from guest writers and bloggers who wish to push their views and opinions through our platform. To get your articles on Nairametrics, kindly send an email to info@nairametrics.com and we will publish it within 24 hours of approval by our editorial team.

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Around the World

Buhari nominates Okonjo-Iweala as DG World Trade Organization

President Muhammadu Buhari nominated the former Minister of Finance and Coordinating Minister of the economy, Ngozi Okonjo Iweala, as the Director-General of the World Trade Organization (WTO).

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Nigeria’s former finance minister, Okonjo-Iweala, gets IMF appointment

President Muhammadu Buhari has nominated the former Minister of Finance and Coordinating Minister of the Economy, Ngozi Okonjo Iweala, as the Director-General of the World Trade Organization (WTO).

This was seen in a tweet posted by the Presidential aide on Digital and New Media, Tolu Ogunlesi, in the early hours of Friday, June 5, 2020.

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In the statement, Ogunlesi said that the current Director-General of the intergovernmental organization, Roberto Azevedo, is stepping down from his position on August 2020, a year ahead of the end of his tenure.

Azevedo, who has been the head of the WTO since 2013, is stepping down at this critical period of global economic crisis and the trade war between the United States of America and China.

This means that the election that was earlier scheduled for 2021 when his tenure was supposed to expire might be coming up much earlier for a new four-year term.

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Tolu Ogunlesi in his statement said, ”President Muhammadu Buhari has nominated Okonji-Iweala as Nigeria’s candidate for the position of the Director-General of World Trade Organization. DG Azevedo is stepping down in August 2020, a year earlier, so the election of the new DG, originally scheduled for 2021, may take place much earlier”.

Details later…

 

 

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Just-in: AfDB board agrees to an independent probe of Akinwumi Adesina

The independent review shall be conducted by a neutral high calibre individual with unquestionable experience, high international reputation and integrity within a short time period of not more than two to four weeks maximum, taking the Bank group’s electoral calendar into account.

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Dr. Akinwnmi Adesina, Lutoyilex Construct Ltd, Fraud, AfDB

The Bureau of the Board of Governors of the African Development Bank (AfDB), has agreed to authorize an independent review of the report of the ethics committee of the bank’s board of directors on the allegations levied against the President of the Bank, Akinwumi Adesina.

This was contained in a communique which was released and signed by the Chairperson of the Bureau of Board of Governors, Ms Niale Kaba, after the meeting of the bureau board of governors on June 4, 2020, with respect to the complaints against the President of the bank.

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In taking the decision, the Bureau agreed that the ethics committee performed its role on this matter in accordance with the applicable rule under resolution B/BG/2008/11 of the board of governors and that the Chairperson of the Bureau of Board of Governors performed her role in accepting the findings of the ethics committee in accordance with the said resolution.

The bank’s board of governors in its statement said, ‘’Based on the views of some Governors on the matter and the need to carry every Governor along in resolving it, the Bureau agrees to authorize an independent review of the report of the ethics committee of the board of governors relative to the allegations considered by the ethics committee and the submissions made by the President of the Bank Group thereto in the interest of due process.

‘’The independent review shall be conducted by a neutral high calibre individual with unquestionable experience, high international reputation and integrity within a short time period of not more than two to four weeks maximum, taking the Bank group’s electoral calendar into account.

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‘’The Bureau agrees that, within a three to six months period and following the independent review of the ethics committee report, an independent comprehensive review of the implementation of the bank’s group whistleblowing and complaints handling policy should be conducted with a view to ensuring that the policy is properly implemented, and revising it where necessary, to avoid situations of this nature in the future.’’

Following the allegations of unethical conducts, questionable appointments and contract awards by a group of whistleblowers and the subsequent clearance of all charges by the bank’s ethics committee, the United States Government, who is the largest shareholder outside Africa, asked for an independent probe of those allegations.

The US treasury secretary questioned the integrity of the committee’s process as well as the internal processes of the bank.

Adesina, a few days ago, met with President Muhammadu Buhari, where he assured of the country’s support towards his travails and his second term bid for the Presidency of the multilateral institution.

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Business News

FG removes cap on petrol price, allows marketers to fix price

The price cap per liter in respect of Premium Motor Spirit (PMS) is removed from the commencement of these Regulations.

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Subsidy and PIB

The Federal Government has removed the cap on Premium Motor Spirit (PMS) price, popularly known as petrol.

This was disclosed by the Petroleum Products Pricing Regulatory Agency (PPPRA) via a memo, which was dated March 30, 2020, but realised on May 4, 2020, titled ‘Market Based  Pricing Regime for Premium Motor Spirit (PMS) Regulations, 2020.

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What it means: With the new development, marketers now have the freedom to fix the price of the commodity and sell above the price given by the agency.

Executive Secretary, PPPRA, Abdulkadir Saidu, explained that the agency would continue to monitor trends in the crude oil market and advise the Nigerian National Petroleum Corporation (NNPC) and oil marketers on the monthly guiding price for the commodity.

“The price cap per litre in respect of Premium Motor Spirit (PMS) is removed from the commencement of these Regulations. From the commencement of these Regulations, a market-based pricing regime for PMS shall take effect,” he said.

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Meanwhile, Nairametrics had reported that the agency announced a new retail price band for oil marketers.

In a circular dated May 31st, as seen by Nairametrics, the downstream regulator said oil marketers are now expected to sell petrol within the price range of N121.50 and N123.50. Part of the circular said:

“Please recall the recently approved pricing regime which became effective March 19, 2020, and the provision for the establishment of a monthly price band within which petroleum marketers are expected to sell PMS at the retail stations.”

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