Behavioral finance has become an increasingly important concept in the last few years as two bear markets magnified the emotional reactions triggered in investors. The consequences for those reactions, such as selling at or near the low, led to many watching from the sidelines as the market raced back to new highs in just a few years.
Part of the equation shows that people simply are not wired to follow Warren Buffett’s advice to “be greedy when others are fearful,” or as Baron Rothschild said, “buy when there is blood in the streets.”
To define the landscape, market-cap-weighted index funds are the market and capture all the ups and downs for better and for worse. Depending on their mandate, actively managed funds may seek to help investors take emotion out of their portfolios.
However, this maneuverability becomes important not just on the way down, but also on the way up. Glee is also an emotion and can cause people to sell a stock after a 100% gain while on its way to a 1,000% gain.
The fact that ETFs offer more and better trading flexibility than mutual funds remains essential. However, this feature of ETFs can also be used more often than necessary—an especially important factor as ETFs previously only delivered beta-focused passive strategies.
The process of moving away from declining markets rests with an advisor’s discretion acting on a client’s behalf. ETF investing allows flexibility to allocate to an established portfolio manager with a disciplined process for managing assets and, if the strategy allows, moving across markets.
Astute investors realize that they can remain prone to emotional responses, as they are often difficult to overcome. For index investors who struggle with discipline, an interest in high-turnover passive strategies or custom indexes (sometimes referred to as alternative beta or smart beta) can be a good quantitative solution for their investment management.
As is a challenge with many approaches, such new custom indexes need a disciplined process for allocation. This represents an area where the value of a financial advisor can really shine. Financial advisors can either develop their own disciplined approach customized for their client’s needs, or can help advise the client on a group of good managers to allocate toward for portfolio manager services.
As more and more investors come to realize the importance of participating in markets, but also understand the emotional toll investing can take, their risk tolerances may gravitate more toward funds that offer disciplined strategies—whether those strategies are truly actively managed or track a custom index.
A prominent indexer once alluded to the intraday tradability of an ETF as like putting a loaded weapon in the hands of investors. Part of this can be true—intraday tradability can work against an investor and increase costs when not used appropriately. However, a pundit should not dictate how much trading an advisor should do on behalf of a client. No pundit could fully understand the best strategy for a particular client’s risk profile.
The important takeaway remains to not let emotions get the best of your clients. If not already in place, implement a plan on how to trade ETFs for your clients. The use of limit orders and stop-limit orders are tremendous tools for a disciplined investing process, but are not perfect solutions either.
If emotions tend to get the best of you, consider outsourcing to another advisor who uses ETFs and has a disciplined approach. The range of the ETF marketplace now allows advisors to build their own lineup of disciplined strategies and diversify across several managers and strategies, each contained within their own ticker symbol. At the end of the day, and during market volatility, do not let emotions get the best of you or your clients when it comes to ETF investing.