A recent report by the International Organisation of Securities Commissions (IOSCO), Sound Practices for Investment Risk Education, discusses in some detail the investment risk facing retail investors and their common and unexpected loss of money from poor investment choices.
The unexpected losses of these investors was facilitated due to a ‘misalignment’ between the individual’s understanding of risks and the level that was appropriate for them, the report explains. What this amounts to is uninformed decision-making, possibly causing great losses and emotional harm.
It is well-known that retail investors lack knowledge of investment risks, with age, gender and experience with financial products dictating skill level to a large degree. The growing field of investor psychology research broadens our understanding and dictates the content of this interesting report.
The Australian Investments and Securities Commission (ASIC) is an IOSCO member, and one of the roles of both organisations is to help protect consumers, with investor education being one way they do this.
Investor behaviour theory
There are numerous investor behaviour theory research papers, and during the literature review conducted for this report, international surveys were drawn on to help determine gaps in retail investor knowledge and actions. Modern Portfolio Theory isn’t really cutting it these days, since many investors (not just retail investors) are not rational and risk averse, do not have an accurate understanding of possible returns, and are not always only interested in wealth maximisation.
In fact, a new theory, Behavioural Portfolio Theory, indicates that it’s possible we invest on a personal as-needed basis, where each level of our portfolio corresponds to a goal or aspiration, from making ends meet to becoming rich. It doesn’t mean investors are risk averse, or not considering their portfolio as a whole. In fact, it offers us a far different perspective on the human brain than Modern Portfolio Theory, which seems to take our humanness out of the equation. (Human beings are not rational.)
The brain is complex, and our responses to risk and returns, and the experiences we carry with us about both scenarios in all their infinite variations, make the average retail investor’s choices flaky on a regular basis. ‘Miscalculations’ as they are being called, are nothing more than poor judgement based on little or no real information. In a nutshell, for the most part retail investors may not understand how to make good investment choices because they don’t have all the information they need, don’t apply the information they do have, and run almost completely on emotional responses. Fear and excitement, disappointment and joy. It’s an irrational rollercoaster. This is why retail investors need help from ASIC.
What the global research shows about investor knowledge
Financial literacy is moderate, but when it comes to investing, globally we fall down. Australian studies reveal that we overall seem more knowledgeable and confident about familiar issues like budgeting, debt and saving, but investing, superannuation and saving for retirement were met with the equivalent of a blank stare.
Canadians’ investment knowledge was generally low; French Canadians fared better, but had problems in some areas including risk/return trade-offs. In the Netherlands, basic financial concepts were understood and known, but few understood the concepts involved in investing, including the difference between stocks and bonds. In the United Kingdom, most Brits felt comfortable managing their money, but complex topics suffered.
Key findings of previous research has revealed that:
- As investors gain experience, their ability to correctly estimate portfolio returns increased
- The lower the returns, the worse investors are at judging their realised returns, possibly because they avoid looking at things they don't like
- Less knowledgeable investors tend to avoid investing completely, with an observed possible causal link between low financial literacy and stock market participation
- Too many fund options may result in less knowledgeable investors making poor decisions with their money, including a shift in assets from bond to stock funds due to being unable to distinguish between bond and equity funds
- Men hold more risky assets than women, with a theory suggesting that expectations of risks and returns differ between genders – women are less optimistic about market performance than men, and men have higher confidence levels and a greater perceived ability to influence outcomes
- Three out of four pre-retirement investors scammed are men
- Sixty-seven per cent more single men trade compared to single women, and 45 per cent more men trade than women overall
- Older people make more investment mistakes when choosing higher-risk assets
What the report has identified are several key areas that retail investors utterly fail in their task of choosing investments that fulfil their goals of either ongoing income or a long-term investment.
Some practices were identified to help with risk education, including:
- a focus on influencing retail investor attitudes and behaviour, and knowledge;
- developing initiatives that use evidence-based approaches to retail investor needs;
- test initiatives with a targeted audience;
- develop initiatives that appear to the investor near the time they are making important investment decisions, in a variety of methods to improve reach;
- send messages for different target groups depending on investing experience and the ways people like to access their information and education resources;
- engage investors using interesting delivery systems and content;
- keep up-to-date with modern technologies and emerging trends in financial markets;
- create educational initiatives that work in a complementary fashion with regulatory actions to enhance impact;
- develop evaluation frameworks to measure outputs and outcomes.