Discover How Much Risk Your Clients Are Willing To Shoulder

Of all the information Financial Planners collect about a client, one can't overstate the importance of assessing a client's mathematical propensity for risk. For example, if you under-estimate a clients risk balance, their portfolio could become too conservative and they may never reach their goals and if you over-estimate their risk tolerance, not only could a client miss their goals but they could sue you for placing them in unsuitable investments - an outcome evidenced by recent gyration in the stock market.

Using a Proper Risk Assessment Tool can become a Form of a Liability Protection

Today, lawyers will confirm that in view of the new Financial Services Reform Act PS146 regulations for Financial Planners that unless they are using professional risk management tools (such as scientific client risk tolerance, deep quantitative analysis and mathematical asset allocation models) in accordance with the best Industry Practices, then liability protection will almost certainly be avoided by respective Personal Indemnity Insurance companies.

The amateur days of hodgepodge home-made questionnaires and techniques that exist are no longer adequate such as trying to get a better understanding of clients attitudes towards risk, planners conducting lengthy face to face interviews to build their portfolios by taking into account their concerns in the areas of needs analysis, income stream analysis process (ie. allocated pension vs complying pension), RBL lump sums and safety and security of investments, ease of management and estate planning. However, behaviour of risk preferences presents a challenging set of issues.

Psychological Testing

Risk tolerance like intelligence and personality is a psychological trait that generally remains the same over time. The correlation between different aspects of risk taking to be high and meaningful must be personalised rather than generic characteristics of a non-specific situation likened to vacuum results.

Having clients pick their risk tolerance on a scale of 1 to 10 is also unreliable because people don't usually do a good job of gauging their own tolerance for risk, especially if they have little investing experience. To help people make and understand good decisions about risk, you have to put things into a personalised context that describes the risk/return trade-offs in terms of their specific circumstances.

For example, to illustrate what is regarded as a vacuum testing response, if you were to ask somebody what they would do if the market went down 15% - buy, hold or sell - the answer is - "It depends". Is the market concentrated in a particular sector? What's happening to the other people? What sort of securities is the client holding? If someone is holding low risk investments, they are going to feel different than if they are holding Burns Philip shares.

Designer All Risk Comfort Zone Model

Studies have found that planners don't usually do a good job of assessing their client risk tolerance because they don't know how to specialise questionnaires in behavioural finance. The problem they have is trying to frame particular pronounced questions in a short five (5)-item questionnaire that is 100% accurate. In other words, the longer the instrument, the more reliability and the better chance of capturing the full richness of the experience.

The way Financial Planners try to get a better understanding of their clients attribute towards risk generally consists of lengthy face-to-face interviews on the topic. However, despite the discussions being educational, no guidance can be developed as to what the planner should do with this knowledge other than usually "go by feel" as to how much risk to build into a clients portfolio.

I am therefore suggesting the use of these subjective assessments like those based on face-to-face interviews to determine risk tolerance of the client, is that most of the clients ended up looking a lot like the planner - suggesting a strong interview bias. Even risk-assessment questionnaires that have numerical scores like those developed by many Dealer Groups rarely explain where the numbers come from and what it means. There are no hardcore numbers underlying their assumption.

With the BCM risk-tolerance test, it takes its cue from academics who have concluded that risk tolerance, like intelligence and personality, is a psychological trait - that is one that generally remains the same over time.

Hence, the Royal Melbourne Institute of Technology Psychology faculty under the auspices of Associate Professor Zeepongsekul devised this test that would meet strict psychometric standards. The standards of IQ tests also apply to risk tolerance explains Dr Zeepongsekul that one person's risk tolerance can be only measured relative to other people's - there was no discreet unit when RMIT, developing the risk tolerance questionnaire for the BCM started out with 40 reliable and valid questions which was later reduced to 20 questions. We provided them with a risk tolerance score and a statement saying this score places the test markets within x percentile of the investing population.

The Risk Meter

The client can immediately see where their score falls in relation to thousands of other completed profiles. They receive a score between 0 - 100, graphed on a bell curve that is divided into five bands according to risk related Style Investor type Asset Mix models with most people falling into group three (3). Only about 3 percent of test takes scored lower than 25 and higher than 81%.

1. Group Risk - Strategic Asset Mix Objectives for Client's Risk Tolerance

This process is the input of appropriate investment objectives for each investment type portfolio; hence the investor type objectives are -

1. These five (5) appropriate Style Investor Type Diversified Mix Models are set by empirical investment asset consultants.
2. Once set, these objectives drive the determination of asset allocation and sector structures and strategies.
3. In addition, for achieving the desired objective for the client's risk tolerance, one of the many features of BCM, also relative scenario testing of risk/return properties of each asset class by altering the underlying asset class according to forecasted returns and economic variables.

In other words, in seeking the advice of a Financial Planner to assist in making decisions that maximises financial gain whilst either not or exceeding beyond his risk tolerance levels.

Universal Style Investor Type Asset Mix Models

Explanation of the Universal Style Investor Type Categories

Conservative

Conservative Investor (0-20 points)
Security is of paramount importance. Just wants to secure income invested in long term guaranteed Fixed Interest Securities for safeguard of capital.

Moderately Conservative

Low Risk Investor (20-40 points)
Preference for stable income stream with some modest growth for preservation of capital. Overall Portfolio Medium to Long term capital security and low volatility.

Balance

Balanced Saver/Investor (40-60 points)
You can see the benefits of investing your funds with caution but have an eye to returns.

Moderately Aggressive

Knowledgeable Investor (60-80 points)
You're willing to trade of some security in order to achieve above-average returns. You're probably not a complete stranger to investment, but would welcome some guidance in how to achieve a reasonable return without unnecessary risk.

Aggressive

High Risk Taker (80-100 points)
You're not afraid to take risks to achieve what could be well above average returns. The equity and property markets hold few qualms and investing overseas is clearly an option.

2. Score Range - A Person's Risk Tolerance Measured Relative To Attitudes, Values and Experiences of a Construct Questionnaire

The part of BCM invention relates to a system and method for analysing client risk tolerance associated with a reality construct investment portfolio Questionnaire.

Risk is involved in a financial decision when the outcome of the decision is not certain. Different people are comfortable with different levels of risk. A person's risk tolerance is the level of risk within which the person is comfortable in making any such decision.

Risk aversion may prevent an investor from achieving what they may have otherwise achieved if the outcome of a financial decision was certain. Conversely, risk aversion ensures that a person is not exposed to levels of risk that are beyond their risk tolerance. A Consumer typically faces a double challenge. Firstly, in making an accurate and meaningful assessment of their willingness to accept risk, as they perceive it. Secondly, in experiencing this assessment in such a way that both what he or she already has in place and the alternatives now offered to them can be evaluated in terms of their risk tolerance.

The beauty with the BCM is it provides Financial Planners with an instant psychometric questionnaire result on the client's risk tolerance plugged into a visual scenario testing customised Style Investor type Asset Mix Model spreadsheet to determine which one benefits the client's risk tolerance score.

Then the Financial Planner using the BCM, having analysed the score on the spot, is able to link each score with an appropriate asset mix empirically designed Style Investor Type Asset Mix Models, according to investor type that is consistent to that person's risk tolerance. For example, a score of 63 translates into a Moderately Aggressive Investor Type meaning a planned asset mix would typically be growth orientated, ie. Australian Shares 38%, International Shares 22%, Australian Fixed Interest 15%, International Fixed Interest 6%, Australian Property 15% and Cash 4%. Furthermore, the portfolio pick identified for the client receives a thorough quantitative analysis check on 3 and 5 year moving averages for performance, standard deviation, beta and tracking error.

The BCM test takers can also find out if any of their answers differ from most people with similar scores. For example, the questionnaire asks where they think their risk tolerance would fall on the bell curve. It is very common that most people under-estimate their score, thus having significant risk than they thought they would. For example, if the client thought their score was going to be under 50 but ends up 60 plus which indicates they are significantly more risk tolerant than they thought they were.

3. % In Group - Behavioural Finance vs Efficient Market Theory

The five (5) multi Style Investor Type benchmarks is designed to target risk objectives based on categorisation of target Style Investor Type growth exposure. These diversified investor type asset classes are built around long-term strategic asset allocation and absolute risk objectives over three (3) to five (5) years based on detailed historical analysis of risk/return best practices represented by a weighted sample of medium and upper quartile fund managers of each of the diversified sector determined by statistic data produced by Morningstar.

This table uses rolling returns benchmarking ranging in length from 3 years to 5 years to indicate the range of growth/volatility returns.

Therefore, with the aid of BCM automatic matching of the psychometric zones with a better class of asset mix by deep quantitative analysis selection process, the Financial Planner is unlikely to perceive the difference in volatility between a well constructed portfolio with a matching zone standard deviation simply by the Financial Planner dialling up or down the asset allocation. However, the client will start to feel discomfort when the standard deviation reaches 1.5 to 2 standard deviation outside that person's risk comfort zone.

The sort of thing we are trying to avoid is where an adviser recommends an extra large asset allocation to a client who has a small risk tolerance without either of them being aware of the discrepancy.

ie. The distribution of returns is symmetrical about this centre point The dispersion of possible returns around expected returns is measured by the volatility of standard deviation in which the actual returns are likely to deviate from expected return due to random factors. Therefore, if an expected return is 16% and the standard deviation is 6%, it would suggest that the actual return would lie within a range of 10% to 22%. The objective of this indicates the probability of negative returns over 6.25 years. The purpose of knowing the level of an active manager makes it very useful when accessing whether a manager's out performance is due to skill or luck or is the client being rewarded for taking the risk.

BCM does not however, expect planners to base their clients' portfolios solely on the information it provides. Instead planners are expected to continue to come up with recommended portfolios based on the clients individual financial needs (ie. income streaming, insurance planning, taxation, social security entitlements and estate planning), then compare the recommended Managed Funds Portfolio Picking - individually blended Fund Managers whose total standard deviation score is mathematical calculated on moving averages for risk tolerance represented by order of Conservative Portfolio with an average 3 years standard deviation of 5.07%, low volatility to Aggressive Portfolio with an average standard deviation of 10.8% high volatility (see table above).

The BCM has it in the Centimetre Perfect Zone

The scientific and mathematic BCM has the processes that generate all the answers. It's a concept that resonates with many Financial Planners because for the first time, they can comfortably say they now have the right tool to get the overall risk battle of mismatch between client risk tolerance and investment strategy needed to realise the client's financial goals.

Reports of the kind produced by the BCM are not effective when they're not illustrated right in front of the client. The more effective process is to have a PC based optimiser that's simple for Financial Planners to use and simple for clients to understand. Then you do the asset allocation illustration right in front of the client and adjust it until you get the appropriate comfort level.

Looking at it from another perspective the only way for people to be able to express their risk tolerance is to see what can happen to the portfolio under a variety of market scenarios. The BCM does exactly this, that's capable of showing the clients a multi risk/return scenario testing so that they are aware of the array of potential outcomes.

The BCM scenario testing ability, I believe, is even more important to the Small Managed Enterprise (SME) or DIY's market because when you consult with these pension funds, the board collectively has to make decisions about the risk levels of the portfolio. They don't have risk questionnaires. They have outcomes-based investing. They look at the trade-offs between different risk levels along the frontier and the outcome. In other words, by using scenario testing or simulation models of asset allocation with portfolio picking and the trade offs of upside and downside. Rather than talking about standard deviation, they understand it better by showing how much money they would loose if there is a one in 10 chance of a bad market.

Financial Planners are finally recognising that the process of identifying risk tolerance must be a totally separate step from financial needs analysis because that the clients needs and what he is comfortable with are not always the same.

Although Financial Planners are still struggling to figure out what to do when the two assumptions don't match, using BCM identifies a scientifically and mathematically match portfolio to the clients risk tolerance, which immediately shows advisers when they need to discuss making risk return trade-offs. Combining that with value-at-risk tools helps illustrate to clients what those trade-offs might look like. No matter how the advisor finally decides to reconcile any gap at least the client is getting a better understanding of the choices he's making and should be much more comfortable with the results.

Financial Planners Must Know The Clients' Limits

Your decision to put your Superannuation into share options or increase your allocation to global shares on the assumption that in the long run, they would outperform all other investments.

How do you feel about it now? Do you wince every time you open the financial pages thinking of the dollars you've lost? Or do you figure it will come good in the long term and accept this kind of volatility as part and parcel of a growth strategy.

Now Financial Planners have reached the challenges, the investment markets have thrown up in the past couple of years depends upon two major factors where advisers have to honestly ask themselves -

• how much risk is the client willing to take and how well do you understand the risk of your investment decisions
• your investment results will only be as good as the ability of those who make the investment decisions.

How much better the result will be for the client will depend on an all encompassing information processing technology that has the ability to meet the tough new regulations by the F.S.R. legislation (scientific matching an investment profile for a clients appropriate risk tolerance). Yet at the same time, Financial Planners will not only make better investment decisions for the client but will be empowered with a better chosen class of investments giving a better overall package to manage a clients investment portfolio with confidence.

The people that are really hurting the most from the negative returns from their investment portfolios over the past two years are the ones who have been deluding themselves that they could lie with the possibility of negative returns. Risk tolerance to some advisers was no more than a buzzword but now realise that risk is not just a vague concept but really does mean the possibility of your investment losing value.

What the B.C.M. can display visually is how clients and Financial Planners can understand that there are two aspects to risk tolerance. The first is, understanding how much risk a client can tolerate as an individual and secondly how much risk is associated with an investment strategy and whether or not it is the risk level that you can tolerate.

What is an interesting combination of ways about people's Risk Tolerance

1. The way we are brought up
2. By the situation we are in (ie. how old you are, whether you have children and how far you are from retirement).
3. Your risk tolerance does not change much - ie. there are 70 year olds who have a higher risk tolerance score than 30 year olds.
4. Your familiarity with understanding of financial issues has a significant effect, ie. the score of visitors to financial web sites who would be expected to have picked up some financial nous in the process had an average risk tolerance score of 64 compared with an average score of 50 for the normal adult population.
5. Based on a proper awareness of your appetite and ability to abort risk as well as a full understanding of the risk of various investment classes, it is unlikely that your risk tolerance will be affected by changing market conditions, ie. the risk profile spanned the tech boom and its consequent crash, an ongoing dive in international markets, a strong Australian sharemarket and then a fall out on most markets post September 11. Over that period, the average risk tolerance scores of the investors barely varied the 55 mark.
6. But the fact that their risk tolerance scores barely budged during one of the most volatile periods in recent sharemarket history does indicate that those who are fully informed about the risk they are taking on, will not be swayed by short-term market movements.
7. This questionnaire type profiling also relies on investors being absolutely honest about what they can handle, either to themselves or to their Financial Planners. There is no point telling your advisor what you think they want to hear. A Financial Planner can only work with what the investor tells them. Having done that, an investor can look at whether their goals can be reached with the level of risk they can tolerate or whether they may need to scale down or defer their goals in some way. The lesson is that you need to thoroughly understand the trade-offs you require to reach your goals and risk associated with that strategy.

A Financial Planner Can Win Trust By Applying Caveat Emptor

To see the link between the recent Australian Consumers Association and the Australian Securities and Investment Commission (ACA/ASIC) shadow shoppers trail (their recent joint survey of the quality of Financial Planners written advice was scathing) and pay attention to four specific trends that have emerged in many countries including the United States and Australia over the past 15 years.

Firstly, governments have recently privatised responsibilities such as healthcare and retirement provisions. Individuals must fund themselves in retirement. Secondly, we need to understand how the law is changing in the consumers favour. If we look after ourselves in retirement, no longer will the standard of caveat emptor be acceptable. Consumers must be able to make informed decisions about their future. Thirdly, we need to look at how other professionals such as lawyers and doctors are pushing decisions back to their clients using "liability shifting" and finally, we should understand how the product marketing, claims to meet the needs of consumer or client.

From the point of view of ASIC or stereotype shoppers report insists planners clearly disclose remuneration fees and conflict of interest and that clients must be able to make an informed decision about who they do business with and how much they pay. Finally, Financial Planners must justify why specific strategies are selected and how they are appropriate to the client.

These specific investment guidelines laid down by law are inextricably linked to "know your client" and "know your product" obligations. Also, it's worth noting that the discussion paper issued by ASIC, outlined the obligation for planners to inquire about the client's aversion to or tolerance of the risk of losing their capital and not receiving anticipated levels of income. The paper suggests that if the clients have conflicting objectives, the requirement of the planner is to assist them to resolve and clarify those objectives. For example, many investors financial needs can only be met with an exposure to growth assets greater than the one they would otherwise select if their financial goals were not an issue.

Personal Financial Profiling Process

Introduction

Many financial decisions are made in situations of uncertainty and so risk is involved. Different people are comfortable with different levels of risk. A person's risk tolerance is the level of risk with which he or she is comfortable.

The whole issue of risk is a difficult one. Risk aversion prevents many of us doing as well as we might financially. Yet some of life's most unpleasant financial surprises arise because we were exposed to a level of risk beyond our comfort zone. It can be equally disappointing to miss an opportunity because someone else wrongly assumed we would not be willing to take the risk involved.

A person's risk tolerance can only be measured relative to others on a constructed scale, in much the same way as IQ is measured. Additionally, even the meaning of "risk" can depend on the situation. When individuals talk about "risk" as they experience it in their personal financial affairs they are not talking about the same thing as, for example, investment researchers discussing the "risk" of an investment.

So, consumers face a double challenge,

• firstly, in making an accurate and meaningful assessment of their willingness to accept risk as they perceive it, and
• secondly, in expressing this assessment in such a way that both what they already have in place, and the alternatives now of offer to them, can be evaluated in terms of their risk tolerance.

The Business Coach Model Profiling system assists consumers and their advisers in meeting this challenge.

In the questionnaire you are asked about your attitudes, values and experiences. Your answers are scored against the system's database and used to produce a detailed report. The questionnaire takes about 15 minutes to complete.

By using the BCM system, you can obtain an accurate assessment of your risk tolerance in terms that are meaningful to you and your Financial Planner. Your Risk Profile report will guide you and your Financial Planner in your financial decision-making. In particular, the report provides the basis for your instructions to your Financial Planner on the level of risk you are willing to accept.

Why are 20 questions needed?

A person's answer to a specific question may be influenced by a particular experience they have had, or their mood at the time. Or they may have misinterpreted the question. Or they may simply have made a mistake.

Statistical studies are used to determine the number of questions needed to provide a scientifically acceptable level of accuracy in an assessment. The accuracy of a questionnaire is a function, in part, of the total score of the number of questions. Because of the nature of risk tolerance more than just a few questions are needed. Twenty questions would be a minimum.

This questionnaire shows that it's accuracy would achieve the high standards on Risk Compliance set by the new "Financial Services Act".

What if the situation described in a question has never happened to me. Or will never happen to me?

There are a number of questions that ask you to assume or imagine you are in a certain situation. These questions are designed to gain a picture of what you would do in such circumstances, regardless of whether you have ever been in them or are ever likely to be in them. Please answer as best you can on the available information.

What if a question asks about a situation where, in real life, I would have (or would seek) more information than is given in the question?

Some questions require you to make a decision based on limited information. While, in real life, you may wish to obtain more information before making your final decision, these questions are designed to gain an idea of what you would do given the limited information. Please answer as best you can on the available information.

What if none of the choices in a multiple-choice question is my preferred answer?

Some questions give you a limited choice of responses and may not include what would be your preferred answer. These are designed to obtain a picture of what you would do given the choices available. Please answer as best you can on the available choices.

What makes a "good" questionnaire?

A good questionnaire will certainly be (relatively) easy to understand and answer. It must also have been developed on sound scientific principles in order to ensure the validity and reliability of its results. The starting point is a pool of potential questions. The trailing process these must go through will identify which questions work (statistically) and which do not. The questions that are effective in a questionnaire are not necessarily those most suitable for an interview.

The Risk Profile report produced from a completed questionnaire provides details of the development of the BCM questionnaire.

Do the questionnaire and report replace discussion between client and adviser?

Not at all. They act as catalysts to, and provide an objective starting point for, a more informed, more focused discussion. Advisers experienced in using the BCM system report that the improved communication leads to clearer instructions from clients and greater understanding, by both client and adviser, of clients' attitudes to risk.

Explanation of Risk Categories

Conservative

Conservative Investor (0-20 points)
Security is of paramount importance. Just wants to secure income invested in long term guaranteed Fixed Interest Securities for safeguard of capital.

Moderately Conservative

Low Risk Investor (20-40 points)
Preference for stable income stream with some modest growth for preservation of capital. Overall Portfolio Medium to Long term capital security and low volatility.

Balance

Balanced Saver/Investor (40-60 points)
You can see the benefits of investing your funds with caution but have an eye to returns.

Moderately Aggressive

Knowledgeable Investor (60-80 points)
You're willing to trade of some security in order to achieve above-average returns. You're probably not a complete stranger to investment, but would welcome some guidance in how to achieve a reasonable return without unnecessary risk.

Aggressive

High Risk Taker (80-100 points)
You're not afraid to take risks to achieve what could be well above average returns. The equity and property markets hold few qualms and investing overseas is clearly an option.

What Does It Mean To Measure Risk

There has been a big difference between measuring risk and perceiving a risk.

The standard method used to answer this question endorsed by years of industry practise is to measure the tracking error of the manager relative to some benchmark.

Perceived Risk By The Advisor

Tracking error has too-obvious deficiencies:

1. The total volatility is mixed with upside and downside risk - upside doesn't matter a lot.
2. And it's measuring relative to household. We need to look at perceived risk through the eyes of the member.

Perceived Risk From A Client

In this regard, we are engaging with a member's perception. The members perceive risk through psychology and the latter emerges strongly when returns are negative as we know.

We need to look at risk with fresh eyes from the vantage point of a member. Since we uncover how risk is perceived, we can devise a risk measure that is relevant to that member. We can all sleep a lot happier at night knowing how close we are engaging with those members' perception of risk. This is accepted that every one member perceives risk differently from older members close to retirement.

By asking questions about our members' attitude to risk, we understand a deeper feeling. As it turns out, the frequency of the bad outcomes is one thing we all consider when we assess risk but we are also wary about the magnitude of the disaster.

Shock Of The Consecutive

There are a number of psychological bias we are dealing with at the moment. After 2 to 3 years negative returns, they are still suffering from the shock. In theory, normally one would predict negative returns 1 in 5 or 1 in 7 years.

Strategic Asset Allocation

Again we go down the engineering root that it is not in the member perception of perceived risk to meet their long-term objectives. The plan comes home to roost in a bear market and the client means by long-term returns is absolute returns.

We can think about these low returns with low risk. This means that we approach our investments from a stand point that forces us to search for assets and strategies that protect capital and generate income over a reasonable time frame. We can immediately reject broad sharemarket extremes and benchmarks, and commence the hunt for assets that help achieve these goals. At each stage, we avoid taking large risks on the direction of stockmarket. It's terribly important to monitor our progress with periodical reviews and take appropriate action when necessary.

Measuring Risk

Why Quantify Risk

It is important to be able to measure and compare the investment risk of alternative investments in a reasonably precise manner. For example, precise measures of investment risk are important when interpreting fund managers performances when selecting an appropriate investment mix and when managing the risk of an existing portfolio.

When comparing the performance of investment managers, it is useful to know not only the return achieved but the level of active risk the manager has taken in producing these returns. Therefore, the higher level of active risk, the more likely it becomes that any superior short-term can be attributed to luck rather than skill.

Risk measures might indicate that one manager's investments have twice the level of active risk adopted by another. Yet the manager might only produce a marginally higher return.

The Normal Distribution

Most of the formal measures adopted by the investment community were developed in the scientific discipline known as statistics. In statistics, the range of possible outcomes and associated probabilities that will occur -

Risk Measure of Normal Distribution

i. The most likely return lies at the centre of distribution of possible returns In finance, the expected (or likely) return has a specific meaning. It reflects each of the possible returns that could occur weighted by the probability of these occurring. However, this is not true for all types of distributions and it's important to differentiate between the most likely return and expected return, which differs under different circumstances.

ii. The distribution of returns is symmetrical about this centre point The dispersion of possible returns around expected returns is measured by the volatility of standard deviation in which the actual returns are likely to deviate from expected return duets random factors. Therefore, if an expected return is 16% and the standard deviation is 6%, it would suggest that the actual return would lie within a range of 10% to 22% in roughly 2 to 3 years. The purpose of knowing the level of an active manager makes it very useful when accessing whether a manager's out performance is due to skill or luck.

Two Useful Specific Risk Measures

The concept of market risk is that all investments will be affected in a similar manner by economic uncertainties. This particularly applies to individual equities securities of the low sensitivity compared to the overall equity market.

Beta Risk

Beta provides an indication of how sensitive an equity asset will change in the market risk premium (return on the market less than cash return). Equity securities that are more sensitive than the average have a beta above 1 while those less sensitive than the average have a beta below 1.

A public market index (eg. The ASX All Ordinaries Index) is generally used to represent the market portfolio and therefore has a beta of one.

To illustrate how a beta can be interpreted, assume a property trust has a beta of 0.5 which indicates that it is less sensitive to market movements than the average listed equity security. A beta of 0.5 means that if the market return were to rise or fall unexpectedly by 10%, property trusts would on the average rise or fall by half this amount; that is 5%.

Duration Risk

Duration is a measure of the sensitivity of an investment to interest rate changes in the same way as beta is a measure of the sensitivity of an investment to the market movement. It is most applicable to fixed interest type of investments. Interest rates and the price of the security have an inverse relationship. This means that a fall in interest rates will generally be associated with a rise in the price of most assets in the economy.

The interpretation of duration is that a 1% fall in interest rates would cause the price of assets to rise by approximately 1% multiplied by the duration of the asset and visa versa. Therefore, the higher the duration, an asset will be more sensitive to interest rate changes than an asset with a low duration.

One Of The Best Ways Of Explaining Risk Is To Understand The Risk Of Parachute Jumping

Before dealing with risk as an investment setting, lets begin with an illustration of an activity - the risk of all risks - "parachute jumping".

Question: What is more risky, jumping out of an aeroplane at 3000 meters with a parachute or making the same jump, without one?

Answer: Jumping with a parachute. Why, because jumping without a parachute carries a definable risk. The outcome is certain death. There is no possibility of an alternative outcome.

This example illustrates a key factor in understanding how the term 'risk' is used in the investment community. Risk is an inability to predict which outcome will occur from a range of outcomes. If only a single outcome is possible, then in investment terms, there is no risk - that's called certainty.

To measure risk, we start by listing all the possible outcomes that could occur. In between, the two extremes lie various outcomes such as spraining your ankle, injuring your back and a variety of others.

Is it worth bearing all the risks associated with parachute jumping?

For most people, the answer is clearly "No". Part of the risk management is to define what risks are involved and then determine which are worth bearing and how to eliminate the remaining ones. There are a number of things jumpers can do to reduce their exposure to risk and increase the probability that the outcome will be successful and exhilarating. This includes adequate training prior to making the first jump, making the first jump under controlled circumstances and checking that the equipment is in a satisfactory condition. For most people, these risk controls make parachuting more acceptable.

The same is true of investment decision-making. Investment outcomes are influenced by a range of different factors. The process of investment risk management is to determine which risks are worth taking and how to avoid those as efficiently as possible.

The Relationship Between Return and Risk

The risk associated with parachuting does not necessarily make for an undesirable activity. If the experience is a good one, the rewards can be well worth the risk. However, to take on these risks, you must expect to be better off than the apparent risk-free alternative of not jumping. It is important to note that the risk/return relationship implies that the risky activities should offer the expectation of higher rewards than the risk-free alternative, but there is no guarantee for experiencing these rewards.

The same principle applies to investments- the higher the risk activity will result in higher rewards. Higher risk assets will attract some investors but not all. Again, personal characteristics such as age, health, attitude and education towards risk will be important.

How Will Parachuting Service be provided?

Another parallel between parachute jumping and investments is that there are numerous ways to undertake each activity. Some people would only be prepared to parachute if they could jump in tandem with an experienced jumper who would control everything on the way down. Others, provided the parachute was opened with a static line so that it could be reasonably assumed that the parachute would open, and finally the experienced jumpers would do free-fall jumps under a variety of conditions.

In exactly the same way, investment services can be provided in different ways. Individuals depending on their capacity to carry risk, demand different solutions. To satisfy these solutions, the BCM has developed many scenario-testing alternatives for the clients to understand their risk tolerances in relation to the possible range of rewards.

The Art And Science Of Risk Investing

After the rise of equity markets in the '90's, many investors have overlooked the importance of managing risk and risk's role in achieving significant returns.

Undoubtedly, there's got to be a reality check after officially experiencing one of the longest downward spiral ever in bear market in history and there is nothing like negative performances to highlight the prevalence of risk as a significant factor in determining the deliverable return to investors.

Sure, we all want an investment vehicle with high returns and no risk but sadly, the reality of the investment market is much less black and white. To be successful in the game of investment, your tactics need to be both psychological and scientific - mollifying your comfort while making the right investment decisions.

As any Financial Planner will tell you, it is an understatement to say that trying to strike the right balance between risk returns in an investor's portfolio is precarious.

What is Risk

The risk element of any investment including a fund, refers to the possibility that you might not get back the amount you originally invested. In other words, risk is the chance you are making or losing money on your investment - the greater the risk, the more you stand to gain or lose. An investor cannot however, look at risk or return in isolation - there are two factors that are interlinked and co-contribute to an investor's ultimate investment strategy.

As a general rule, funds with the highest potential returns also carry the highest risk factor. But remember, even the "safest" funds can involve some degree of risk.

What are the Main Types of Risk?

The type and degree of risk a managed fund experiences depends on its objectives, strategy, management style and the type of securities in which the fund invests. Managed funds may experience any combination of the risks listed below which are some of the main risks an investor may encounter.

Credit Risk

The risk that an issuer may not be able to meet interest payments or repay principal. Changes in the financial strength of an issuer are reflected in the credit ratings of its debt obligations and may affect their value. A fund that invests in debt obligations of an issuer with a low credit rating will experience more credit risk than a fund that invests in debt obligations of an issuer with a higher credit rating.

Exchange Risk

The risk that the value of an investment may be diminished by movements in the exchange rate of foreign currency.

Interest Rate Risk

The risk that changes in interest rates will affect the resale value of the debt securities held in a funds portfolio. Generally, interest rates and debt security value are inversely related. As interest rate rises, the resale value of the debt security falls and visa versa. Generally, bonds and certain shares are more vulnerable to this risk than other types of investment.

Liquidity Risk

The risk that the security in the funds portfolio cannot be sold at a fair price within a reasonable time (the securities are not liquid). Liquidity is generally related to the market trading volume for a particular security - if the trading volume for a security is low, the liquidity risk of the security is low, then the liquidity risk of the security risk is high and visa versa.

Market Risk

The risk that the price of the security held by the fund may fall, thus reducing the value of the fund's investments.

Non-Diversification Risk

The risk that a fund may invest in fewer issues than if it were a diversified fund. In addition, the fund may invest a significant portion of its assets in securities of companies doing business in a comparative small number of economic sectors. Because of these potential investment considerations, the value of the fund's shares may fluctuate more wildly and that the fund may be subject to greater market risk than if the fund invested more broadly.

Political Risk

The risk that political actions, events or instabilities may result in unfavourable changes in the value of the security held by the fund.

Regularity Risk

The risk that the government regulations may affect the value of the security held by the fund.

Opportunity Risk

The risk that by committing money to one investment vehicle or asset class, an investor may miss out on the opportunity of greater capital growth or returns through another investment vehicle or other asset class. Most commonly occurs when investors are linked to cash over the medium to long term.

The Risk Of Legislative Changes

Regulatory and Tax Risks

Individuals build up assets for their retirement in a variety of ways. Some of these involve taking advantage of the tax incentives the government has provided through the Superannuation system. Historically though, many Australians have saved largely outside the Superannuation system with a significant component of saving involving borrowing to buy a home and repaying the mortgage prior to retirement.

The major consideration is deciding whether to save inside or outside the Superannuation system as the regulatory and tax rules that will apply in the future. The government uses the tax system in two conflicting ways. The first is to provide tax incentives that encourage people to act in a particular manner such as to lower the rate of tax applied to Superannuation funds and capital gains tax concessions to encourage people to save, thus to reduce the number of people in the future that requires social security support in their old age.

The conflict arises with the use of the tax concession, reducing current revenue and as government recognises that the future economy won't be able to sustain the age pension, either the level of benefits will have to be reduced or the number of recipients will have to be reduced.

The key point in the future that the government will have to balance is to encourage the population to continue to save for their own retirement with financial tax incentives, get a save time, due to revenue constraints and limit individuals to tax concessions.

The risk of legislative changes

It is essential to recognise that the rules and taxes can change and that if the past is any guide, they will change again in the future.

It is recognised that current contributions under the Superannuation Guarantee Levy are likely to be insufficient on their own to provide adequate financial security in retirement and in most cases, individual saving will be required either inside or outside the Superannuation system.

The risk investors have to face is will the agents, ie. politicians behave in a manner that benefits them and the way Financial Planners are remunerated. In the same way, people are concerned with investment risk through diversification; likewise people can spread their investments across a range of legislative areas.

Major Risks When Accumulating For Retirement

To achieve a desirable lifestyle throughout retirement, realistic objectives must be set and a planned development to achieve them. The most valuable asset for many young and middle-aged people is their income earning ability, which can be viewed as an asset called human capital.

An investor's human capital is an important component of wealth with the proviso that it must be viewed as a declining asset whose value will typically fall as retirement approaches and future years of income earning reduces.

In any financial or investment planning process, there are two important stages -

1. The estimated level of investment risk and return that can be expected from various investments available in the market - recognising that the premium return and market risk is the same for everyone - that investors cannot be expected to be rewarded for risk that can be easily and cheaply avoided through diversification.
2. The determination of an investor's capacity to carry risk. For example, an investor exposes himself to a single investment or specific sector with all his savings, thinking that he is going to get 5% premium return but market conditions expected will be considerably different. It's important to recognise that the ability of an investor's capacity bearing market risk depends upon investment horizon - age, experience, wealth, capacity to save and spending patterns.

Therefore, embarking on a chosen retirement course that will ultimately lead to retirement and beyond, individuals face two types of financial risk:

A. Investment Risk - is the possibility that the return in the chosen investment will be different to what was expected.

Different Types of Returns

The investment risk reflects the fact that the actual return does not always equal the expected return, and this deviation of returns will vary across different types of assets.

1. Inflation Risk

   While the dollar amount promised to cash investors is virtually certain, its future value in terms of goods and services that can be bought when the money is received is uncertain. This uncertainty is related to unexpected changes in the price of goods and services, measured as a rate of inflation over the intervening period.

   It recognises that investors save not to just have more money in the future but to have the ability to buy goods and services to meet future living needs. When the cost of goods and services rise faster than the expected real return (ie. inflation adjusted return), the return will be lower than expected. For example, during the unusually high rates of inflation in the 70's and 80's, significantly eroded the real wealth of Australians, particularly those who invested their savings in cash or government bonds.

   For someone who wants to eliminate both the inflation risk and horizon risk, uncertainty might choose a 5 year Inflation Index Bond.

2. Volatility Risk

   The commonly held view that equities have a much higher volatility (investment risk) than cash and bonds return, lies somewhere in between.

3. Market Risk

   Interest rate movements and inflation which affects almost all securities in a similar manner whilst investors holding a diversified portfolio can be expected to be compensated for market risk.

4. Non-Market Risk

   Factors which affect individual or small groups of investments might be factors which affect a particular industry sector or a particular company. Investor holdings exposed to a single stock fundamentally cannot expect to be compensated for this extra risk.

5. Rewards for Bearing Investment Risk

   Investment risk implies that actual return each year can almost certainly be different from the expected return. When we plot the asset allocation class of investments over a period, that is the range between the highest and lowest returns has been much greater for equities than bonds or cash. Equities behave in a volatile fashion but equities deliver a higher rate. The extra return on risk premium earned by shares over the period has to be worth it for bearing the extra risk, ie. equities 4-7% over cash, bonds 1-1.5% over cash.

   But even though these more volatile assets earn average higher long-term rate than low volatility, it shouldn't be taken to imply that equities always earn a higher return than cash. In fact, from the period between 1975 to 1997 (10 of the 23 years), equities earned less return than cash.

B. Wealth Risk - is the prospect that the individual will outlive his/her savings and be unable to support him/herself late in life.

The risk that individuals will spend all their savings before they die

• The accumulated value of investments at any date is uncertain
• The accumulated value of any investment assets depend upon -
  1. the rate of savings each year up to retirement
  2. the number of years of pre-retirement
  3. return on investment
  4. the rate of spending in retirement

At any time of life, savings reflects a trade-off between spending money now and setting money aside to be spent at some later date. It doesn't matter what the purpose of saving is, the principle is always the same. The greater proportion of income spent on current needs, the less that will be available later, but to lower your wealth risk, the higher your pre retirement years savings rate. If you are going to limit a long-term investment horizon to a class of assets offering a low level of returns because of low volatility risk, you must expect an increase in wealth risk (having insufficient wealth to fund living expenses later in life).

However, on the other hand, the problem with the asset classes with the higher expected returns also carries volatility risk, which also increases the chance that actual returns will be different from the expected returns.

1. Spending Factor

   How long an investment lasts after retirement is the level of after tax return inflation and the rate at which money is spent. Now the uncertainty of how long we are going to live. Otherwise if people know that, they would tailor their investment to a precise date which may force retirees to spend conservatively with the result many may leave assets to their heirs.

2. Liquidity Risk

   The advantage of investment in illiquid assets is that these assets should offer a higher return than liquid assets with equivalent volatility risk to compensate for the difficulty associated with realising the investment.

3. Agency Risk

   Choosing a Financial Planner can be risky because their incentives may not be perfectly aligned with those of their client.

   There is no guarantee that investors will be compensated for accepting higher risk. The main question for investors is which risk might they be compensated for and which risk that they won't be. Unfortunately, this question cannot be answered precisely. Part of the skills of a professional manager is making judgements on risk should be carried out and those that should be eliminated.

4. Compensation for Holding Risk

   When faced with two alternatives that both offer the same expected outcomes, the one with the greatest certainty will be preferred. Investors will only accept greater uncertainty if the outcome if more attractive.

Although historical equity premiums has averaged about 5% pa., this average varies depending on changes to the global economy, changes to structure of corporate tax regulations and development in technology.

Anyone wanting to attract investors to more risky ventures must offer them the likelihood of higher returns than those available from less risky ventures. Investors will continue to rationalise between investment premiums, volatility, uncertainty and attractive returns.

Evolutionary Trends

You Can't Trust Your Instincts If You Want to be a Successful Investor

Investment markets can be cantankerous and irrational. In favour one day, hopeless the next. All ups and downs have left many of us feeling like we are dealing with casino gambling rather than rational investments.

But is it really the market at fault? There is a growing body of research that shows investment markets are never going to be rational because they are really the result of investors gut instincts - many of them a hangover from the old days, rather than logic.

Why We Think The Way We Do

Much of the writing of the human brain was developed when we had little more to ponder than where the next meal was coming from, how to find a mate or which way to run when confronted by a sabre-toothed tiger. Civilisation is a recent innovation in the evolution of man.

Some neuroscientists describe the human brain as a Maserati when it comes to solving ancient problems such as recognising the short-term trends or generating responses lightening-fast to emotional problems. The fight or flight instincts, for instance, are automatic because they are wired into the nether region of the human brain.

But our minds aren't as good at more modern problems such as recognising long-term trends or focusing on several factors at once. Our ancestors didn't have to do things that we do everyday.

The unfortunate truth is humans are psychologically programmed to be investment dunces - to buy high and sell low, to chase last year's "hot" sector and to think you're smarter than the average investment analyst.

Put us all together and it's much easier to understand why markets behave the way they do, why predictable, otherwise boring, stocks can trade at high price-earning ratios and why some stocks can deliver unexpected profit downgrades and get savaged for more than their bad news is worth.

When investors have their wealth at stake, their primitive instincts can take over. You see fear and greed and fight for a fight. They just want to be in or out. But when gains and loses aren't as apparent, they don't behave in the same way. If the price of a car goes down, everyone celebrates but if the share price falls, everyone focuses on the loss of wealth.

The study of "Investor Psychology" or "Behavioural Finance" was boosted last year when US cognitive psychologist, Professor Daniel Kahneman won the Nobel Prize for economics for his work is this area. This showed that humans are simply incapable of fully analysing complex decisions when the consequences are uncertain. What we do is to rely on shortcuts or rule of thumb.

Our ability to predict the future sends our financial decision-making processes haywire. Instead of approaching the decision logically, we rely on quick fixes such as hot tips, the latest news event and even that guy next door is going to solve the problem.

Curbing the Habits

As with other irrational behaviours such as phobias, addictions and emotional hang-ups, the first step in fighting them is to be part of them - successful behaviour can be developed by being aware of some of the things you may automatically do, hopefully you can check yourself before you act on impulse. But Professor Kahneman warns that our way of thinking is incredibly deep-seated "Merely learning about illusions doesn't cure them" he says. The goal is to develop a skill of recognising situations in which a particular error is likely. In such situations, institutions cannot be trusted and it must be supplemented or replaced by more critical or analytical thinking.

Einstein You're Not

Ego is one of the basic drivers of the human mind and there is substantial evidence that investors are full of it. Coupled with our inherent optimism, ego can be dangerous.

How good a driver are you? Most people believe they are above average even though a sizeable number of people must be wrong. A similar question was once asked of a group of MBA students - "how many of them thought they would finish in the top half of the class". The response was 100%.

Translate this into the investment arena and it's easy to see why so many of us believe we can outperform the market with 'do-it-yourself' super funds and can beat professionally managed products, and why so many of us believe investment basics such as diversification are for others - less smart people.

The problem, says Professor Kahneman is that optimists overestimate their ability to control their fate. They tend to dismiss the role of chance and credit skill for lucky windfalls. A little knowledge can be a dangerous thing. Also, research by Professor Kahneman has shown over confidence typically leads to more trading by investors and more trading leads to poorer results. In one study, men were found to trade 45 per cent more than women but earned 1.45 per cent less; single men were 67 per cent more likely to trade and earned 2.3 per cent less.

Professor Kahneman suggests that to curb our optimism we should consider counter measures such as - always consider the downside and be aware of what you don't know and because we are likely to remember the success, we should keep a list of failures to ensure we learn from them.

Diversity may not control your sense of omnipotence but at least you'll be spared the pain of putting all your money in a great deal that goes wrong. The more you put your investments on autopilot, the less risk you will crash them.

Avoid the common pitfall of overreacting to every piece of news but don't ignore news that contradicts earlier discussions just because you don't want to admit you might have been wrong. In the majority of cases, remember it's better to do nothing than something or another way of putting it - if you're in quicksand, don't wriggle.

Losing your Way

One of the key tenets of behavioural finance is that incurring a loss hurts the average investor about 2.5 times as much the pleasure they get out of making a profit. That leads inevitably to loss aversion - we loathe cutting our losses and admitting mistakes.

This also leads to regret which Professor Kahneman says, intensifies the pain of losing. He says investors also put undue emphasis on hindsight and believes events are much more predictable than they are. So what seems a sensible risk at the onset often becomes a blatantly obvious mistake that should have been avoided after the investment has been lost.

To make matters worse, we are just as inclined to regret missed opportunities, as we are losers. That explains why people invest in things they know are probably unwise, being the rational thought is the fear of missing out.

Investors often try to avoid the regret by employing Financial Planners (who can cop the blame if there is a loss) going with the herd (it hurts less if everyone is losing money) or investing on past performance.

Another advantage with a Diversified Portfolio is to make one concentrate on the loss makers and remind us of the ways to avoid this in the future.

For example, Bill and Bob each have a diversified investment portfolio of five investments. Bill's investments have risen by $100 each in the past year, representing a total gain of $500. Bob's investments have been mixed - some are up and some are down but overall, he is also $500 in front. The problem is that while Bill is plainly satisfied with his investments (and his advisor), Bob will focus on the loss making in his portfolio and human beings, being the way they are, it's odds on that Bob's Financial Planner will get a wake up call wanting to know why he put him into a looser.

This fear of loosing makes us hold onto dud investments rather than selling, taking the losses and admitting our mistakes. We confuse the value of the investment with what we paid for it. The fact we paid X for something, anchors it. That's why you see projects, particularly government projects, going ahead when they should have been canned half way through. They don't want to waste the $100 million they sunk into it even though finishing the project will be a failure and cost another $100 million.

The suggested counter measure is to learn as much about the long-term history of markets and decide on the long-term strategy within the "risk tolerance" you are prepared to wear and then turn off.

Don't give into the need to check on you portfolio every 10 minutes. Fear is a powerful motivator and panic is a great way to lose more but if the decision is clearly wrong, cut your losses.

Be just as ruthless in analysing your success as your failures. Understanding why things happen can help you make better decisions.

Seeing Things

One thing we are very good at is recognising patterns so that we sometimes place importance on patterns that are meaningless or not there. For example, the following sequence occurred when a coin is tossed several times: H.H.H.T.T.T. OR H.T.H.T.T.H.

Most people believe the second sequence is more likely to occur because it looks more random whilst the first appears systematic even though both are equally probable. The explanation is that we tend to downplay uncertainty and project the state of the world into the future. That's why we think that the sharemarket or the fund manager has done well into the future and ultimately why investment bubbles and burst overshoot any levels that seems halfway sensible. That's why in absence of better information, we also assume the latest prices are about right or why we think the growth shares of a few years back are dirt cheap at price earning ratios still well in excess of 20.

A study in 1998 found share investors typically sell shares that will outperform the market in the future to buy shares that will give them lower returns. In other words, they sell winners to buy losers. Professor Kahneman believes this is partly due to over-confidence and partly due to seeing patterns where none exist.

Suggested counter-measures avoid the tendency to talk long-term and act short-term. Remember, your brain can deceive you into thinking that anything that happens a couple of times is a trend.

If you have an appropriate strategy, stick to it and you should always ask yourself before making a decision whether there is a chance that the reason behind your planned trade might be random. List the reasons of not to sell before you commit.

You've Been Framed

As anyone who has watched the television show "Yes Minister" would know there are many ways of making judgement based on a piece of information based on how it is presented. Perhaps our ancient ancestors didn't see the need for subterfuge but we tend to process information in the context in which it is framed or presented.

Let's say you have just had a $2,000 windfall. You have two options:

1. To receive another $5,000 or a 50 per cent chance to win $10,000 or
2. A 50 per cent chance of winning nothing.

Now imagine a $30,000 windfall. Your options are:

1. To lose $5,000 or a 50 per cent chance of losing $10,000 versus
2. A 50 per cent chance of losing nothing.

Most of us feel the two situations are quite different; one is about making money; the other about losing it. We'll generally choose the same thing in the first question but take a gamble in the second and most of us will also ignore that we've suddenly become richer regardless of which option we choose.

However, in rational terms both questions are identical because we are looking at definitely being $25,000 richer versus equal odds of being $20,000 or $30,000 richer, not the gains or losses along the way that should matter.

Another example is being offered either cash or a fancy pen. Most will choose the cash but extend that choice to cash, a fancy pen or a cheap pen and most will go for a fancy pen. It's an old sales trick to get the buyers to commit by offering them an inferior option to the one the seller wants to push.

Suggested counter-measures: look at the same information from as many angles as possible and consider the big picture behind the facts.

Summary

Investor psychology can be a frustrating science because there is fuzzy logic, contradictions and no absolute or clean-cut answers. Basic investment disciplines, such as having a long-term strategy, researching discussions, buying and holding and dollar cost averaging can help offset our tendency to act on poorly processed information.

It is good news too that our brains are configured to learn from experience. It's a pity evolution doesn't work a bit faster.

Behavioural Finance (Science) vs Efficient Market Hypothesis

Investors, individual firms and governments generally react to rational behaviour, which is primarily based on the supply and demand. This theory underlies the Efficient Market Hypothesis (EMH), which concerns the information efficiency of the market and identifies how rational economic participants should behave. A market is considered efficient when the prices of the security traded reflect all the available information, hence leading to a fairly price securities that represent their underlying value whereas Behavioural Science acknowledges that the fact that investors do not always behave rationally and provide an alternative paradigm to the EMH.

Behavioural finance suggests that due to the way people think, there are heuristic (serving to discover trial and error) and judgemental biases that can arise in decision making. These biases can lead to bad decision-making that translates into poor investment outcomes. Behavioural finance looks at how individuals actually think and behave.

While behavioural science is grounded in decision-making theory and psychology, EMH on the other hand, is based on the economic theory. Economic theory is important because it is the benchmark, which provides the useful guide. In financial markets, it will help us to determine what is fair value. But at the end of the day, it is only psychology that can help us understand why markets actually deviate away from fair value.

Behavioural economies (psychology and economies) is particularly pertinent to investment markets where bubbles and crashes suggest that investors are often anything but rational. Understanding how investment psychology drives investment markets helps us better understand why markets do what they do. More importantly though, being aware of how we are personally affected by psychological illusions is necessary, if we are to become more savvy investors.

For much of the post war period, the dominant theory was that financial markets was efficient - being the key aspect of the so-called efficient market hypothesis are that all relevant information is reflected in the asset price, referred to as information arbitrage efficiency done in a rational manner known as 'fundamental valuation efficiency'.

With the economic theory and analyses, the critical assumption under pinning the EMH is that individuals (investors) are rational in the way they make decisions and it was generally concluded that all relevant information is quickly reflected in asset prices and that short-term price movements are pretty close to the random walk that is sharemarkets are unpredictable yet this led many to conclude sharemarkets were efficient.

What then are some best practice methods that fund managers, investors and decision makers could adopt in order to enhance their skills. It is easy for the fund managers to control their emotions because it's not their money at stake.

However, given investors disenchantment during the period of negative returns, investors need to be confronted by their financial advisors by helping to appease investors by asking them to look at the long run and stick to their game plan.

Even investment professionals can fall prey to behavioural biases with policies and procedures in an attempt to avoid them. For example,

1. The less experimented analysts fall in love with their stocks they cover and it would be a good idea to get critical independent evaluations done.
2. People tend to be conservative in adjusting their expectations to new information and do so slowly over time.
3. People in general tend to be overweight in spectacular or personal experiences in assessing the probability of events occurring. This can result in an emotional involvement with an investment strategy if it has been winning recently, an investor is likely to expect that it will continue to do so.
4. People tend to focus on occurrence that draws attention to themselves (such as a stock or class of asset that has risen sharply in value).

   Due to this type of above behaviour, people tend to be over confident in their ability. Interestingly, men tend to be more over confident than women which results in men trading more than women and generating poorer investment returns than women. This also says that people require less information to predict a desirable event than an undesirable one (wishful thinking).

5. Crowd psychology can have a contagious effect and can magnify errors in an individual's judgement, ie. mass communications, the threat of losing or missing out, financial wealth or a strong belief that share prices can only go down.
6. The influence of investor psychology can have several implications for investors - ie. Investment markets are not just driven by the fundamentals but also by the irrational expectation and erratic behaviour of an unstable crowd.
7. Investors need to recognise that not only investors markets are highly unstable but they can also be seductive, ie. buying near the top and selling near the bottom. In other words, investors must be aware of how they are influenced by the lapses in logic and crowd influences or do I have a tendency to be over confident in my ability.
8. Investors ought to choose an investment strategy, which can withstand downsides whilst remaining focused on the broad financial goals.
9. Finally, if an investor is tempted to trade, they should do so on a contrarian basis, ie. buy when the crowd in bearish and sell when the markets are bullish. Extremes of bullishness often signals market tops and extreme bearishness often signals market bottoms.

The individual versus the crowd dynamics occurs to some extent - in the institutional investment market. Here active managers performances may be measured against a benchmark but if they are unable to perform well - for whatever reason - they may end up hugging the benchmark. The outcome of such an activity is that these managers get paid active fees but only delivering index performances.