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Momentum FundsAtWork recently held an Investment Conference in which this presentation was held

How should advisors and investors think about the investment decision-making process?

This brief synopsis proposes that the two pillars for making efficient investment decisions are to understand what goal you are trying to achieve (termed Goals Based Investing) and what risks you are prepared to take in order to achieve your goal (termed Risk Budgeting).

In developing a framework for decision making that incorporates these two pillars, it is useful to spend some time understanding some of the dynamics of decision-making that a typical investor goes through when faced with the problem of how and what to invest in. After the two pillars have been described, a few of the more important insights in this area (termed behavioural finance) will be highlighted.

The synopsis will conclude by bringing the two pillars and some of the insights from behavioural finance together and present a simple framework of what you should consider when providing advice on or making investment decisions.

Goals Based Investing is the discipline of explicitly defining what an investor is trying to achieve. The “goals” could be, for example, a specified Rand amount or a rate of return that would lead to an acceptable pension at retirement.

The key issue about Goals Based Investing is that it considers the particular needs of an investor and what the investment needs to achieve in order to allow the investor to meet those needs. What it is not is a process of identifying with a particular peer group for instance, as this does not target on the specific needs of the investor.

In order to achieve a particular goal, the investor needs to take on some investment risk. Risk budgeting is the process whereby the various risk/return trade-offs needed to achieve a particular goal are identified and explicitly stated.

Unfortunately, investment risk and investment return are opposing forces, you can’t expect to get high investment returns without taking on investment risk. The Risk Budgeting approach will allow you to assess what is possible and what is not possible.

As a simple example, if an investor wants a relatively high return and is not prepared to accept risk in terms of a negative return, the risk budgeting approach will allow you to express that a) either you need to reduce your required return or b) you need to accept a higher level of risk.

One of the key insights of behavioural finance is that investors do not necessarily evaluate investments from a pure risk / return trade-off perspective. Investors are governed by fear, greed, unrealistic expectations etc, which may cause them to act in a way that from a purely objective point of view may seem irrational. So investors will exit the market after equity markets have fallen, fearful of more losses and not considering that after equity markets have fallen they should offer a myriad of profitable investment opportunities.

So for example risk based questionnaires are increasingly being considered as not being an effective way to assess an investor’s risk appetite as the manner in which an investor answers the risk questionnaire may have more to do with the way that the investor is feeling on a particular day rather than be based on an objective measure of the investor’s risk tolerance.

Investors also tend to invest in such a way as to maximize their utility function. Now this means that an investor wants to invest in such a way so as to maximize their satisfaction (which has nothing to do with risk and return because this measure is so personal).

All of this, means that an independent third party may be able to make better investment decisions than the investor themselves, as emotional aspects of the investor’s decision are stripped away. This is especially true when the investor has very little investment knowledge themselves.

In addition, where an investment strategy is defined it would be useful to set-out the best and worst case scenarios upfront and how an investor should react, if at all. This may assist in allowing the member to be more objective when, over the short term, the investor’s portfolios do not perform as he would like them to perform.

The starting point of any investment decision making process is to understand the investors’ characteristics. These characteristics include but are not limited to; how old each investor is, how much they are willing to save, what the investor is trying to achieve (i.e. what is their goal), how much and what types of risks can the investor tolerate. Where the investor is a retirement fund, this information will cover the demographic profile of the fund.

The rest of the framework will focus on a retirement fund as the investor.

Once you understand the needs of the fund, it is appropriate to come up with a default investment portfolio that will meet most of the needs of the members, which balances the goals of the majority of the members with the risks that they are willing to take. The default approach is prudent as it will help mitigate any tendency for members to chop and change their investment approach which could be very detrimental to their long-term savings if they make bad decisions (e.g. such as investing in cash after markets have fallen and then missing out on any recovery in the equity market when it happens).

A prudent investment approach for a retirement fund should take into account that the members’ needs change as they come closer to retirement. Again in line with the default option proposed above, it is prudent to build investment strategies that take these changed circumstances into account and as far as possible automatically move members into portfolios that are most appropriate for their needs. In the simplest form this may be offering members a pre-retirement switch to more sophisticated models, such as life staging, that move members into portfolios that are more in line with their needs.

To digress quickly, when defining a default portfolio, you should bear in mind that you are trying to address the needs of the majority of members. You will never be able to cater for every member’s particular needs. There are mechanisms, such as member choice, that can be set up to cater for these member’s needs.

From an investment portfolio construction approach, once you have established what the members goals are, it is relatively straight-forward to identify the type of investment product and the basic mix of equities, bonds and cash that would be needed. So for example, if the members require long-term growth that would reasonably achieve a return of CPI+5% p.a., a portfolio that maintains an asset allocation not too different from 65% in equities, 25% in bonds and 10% in cash should be able to achieve this goal.

Obviously when you do select a portfolio, you need to understand the philosophy and approach of the portfolio and how it is managed in order to meet the objectives that you have established.

Finally, it is crucial to measure the performance of the selected portfolios against the required objectives. In measuring this performance you need to keep in mind what the market circumstances were, what the performance potential was and how the portfolio performed. It is important to stress that for retirement funds in general, investments is a fairly long-term game, so performance should be measured over a reasonable period. Focusing on monthly, quarterly or even annual performance may not be an effective way of evaluating whether the portfolio is meeting the longer term objectives