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.
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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.