Never invest with a "rearview mirror" and never give excessive importance to market volatility: these are two of the main recommendations to investors of the behavioral finance which Professor talks about in this interview with FIRSTOnline Alexander Previtero, Italian by birth but American by adoption, professor of Finance at the University of Texas, as well as Advisor to Allianz Global Investors. Here are his answers.
FIRSTonline – Professor Previtero, in a moment of high volatility of the financial markets, how can behavioral finance help savers to make more rational choices?
I will predict – Behavioral finance is the key to making us understand the reactions of investors and allowing us to understand what are the motivations behind their behavior. The current volatility can be explained with one of the pillars of behavioral finance, namely what in technical jargon is called Loss Aversion (in Italian aversion to losses). Individuals tend to have an asymmetrical reaction to the results obtained with their investment: we feel much more suffering from the loss we suffer than the benefit from the gain we achieve. Taking a practical example of what has just been said: when a stock in our portfolio loses 4% in one session, the next day, in order to be truly satisfied, we need the same stock not only to fully recover what was left on the ground , but close up 8% or more.
This principle contained in the "theory of economic decisions" developed by Nobel Prize winner Daniel Kahneman explains well some of the psychological conditions that underlie investors' decisions and can be used to try to understand the natural tendency that influences equity investment.
FIRSTonline – By virtue of what has just been said, how should the investor behave in the face of market turbulence?
I will predict – We need to take into consideration the time horizon of our investment and avoid falling into the obsession with checking the quotations of our share every minute.
FIRST online: So “sleeping investment”?
I will predict – Exactly, we need to adopt what I call “the ostrich strategy”, i.e. avoid looking at the reports all the time. For example, I look at mine once a year. Even in the case of a black year like the one experienced in 2007-2008 I must never lose sight of my investment time horizon, looking at what happens with the right lenses. The most important thing is to maintain a long-term vision, going beyond the short term.
The financial intermediary for his part must help the investor to enter into this perspective, making him understand that his investment could face upward volatility, but also downward volatility. When we see a stock suffer losses we have to ask ourselves: "Should I liquidate my portfolio at the end of the month?" In case the answer is no, and it is in most cases, don't panic. In summary: you need to look at your investments with a frequency consistent with your investment horizon and your risk/return profile.
FIRSTonline – In your opinion, to normalize the market, would it be appropriate to intervene on High Frequency Trading, with a regulation that is able to curb the too frenetic trading of large investors and restore financial democracy by trying to reduce information asymmetries?
I will predict – I don't know how much High Frequency Trading is able to move the markets. Its impact on quotes is most often temporary. The individual investor cannot compete with the titans, he only invests small capital in the stock market, the money he can afford to lose.
With regard to regulation, it must be remembered that each regulation has benefits but also costs. I don't know if introducing restrictions of this kind is good for the market. Looking back, ten years ago the price impact was determined by the size of financial transactions, not the speed with which they were executed and even then it was considered an unequal fight. In the event that action should be taken today, by implementing the rules for High Frequency Trading, particular attention must be paid not to compromising the efficiency and transparency of prices.
On a theoretical level I agree that when we talk about agents making investments in a nano second when others can't even dream of doing so it's not right, but in these cases the battle is only between the heavyweights, the small investor is not affected.
FIRSTonline –Going back to behavioral finance, how do you train savers' minds to make rationality prevail over emotions? Do you have any other advice?
I will predict – Individual investors tend to unknowingly exhibit behaviors that harm them, first of all chasing past returns. When I look back to yesterday and see a positive trend, the spontaneous reaction is to invest. In this context, however, we need to carefully weigh our choice because the real risk is that of buying a security at a high price and then selling it at a lower price. To give a practical example, think of the Dot-Com bubble of the early 2000s. Many decided to invest simply because they looked at the earnings of others, even though they were aware of the fact that shares could be overpriced. In this case the emotional reaction that takes over, in behavioral finance, is called regret aversion. We are driven to invest by the fear of missing out on a gain that others have managed to achieve.
Other mistakes to avoid are overconfidence and customization. Often, when we make investment choices, they tend to affirm or deny our ego. When I get negative returns, it's someone else's fault, but if the results are positive then it's thanks to me. In addition, often when I reach earnings I decide to increase the investment. If things go wrong, “who knew it”?. The investor must rationalize, be aware of the trends just described and try to control them.
FIRSTonline – Wouldn't it be wiser to take into greater consideration the roe and price earnings of the listed company?
I will predict – Price earning varies based on certain characteristics, such as growth. In the United States, many of the listed companies have high Pe because they have a high growth margin (the Pe is higher if the earnings are lower). In a context like that of the Italian Stock Exchange, where there are few companies that grow a lot and quickly, it may still make sense to use the Pe.
FIRSTonline – Speaking of Italy, according to your studies, what are the most obvious mistakes made by investors?
I will predict – In Italy there is an excess of investment in the family. Italians tend to invest in the things they know. The clearest example is government bonds. It's as if Italians were afraid of what they don't know, giving more value to what they do know. It's not a trend that belongs to us alone, in Canada 60% of Canadian dollars are invested in Canadian equities.
In Italy, given that we live in a context in which the stock market is underdeveloped, we must understand that there is a world available and that the possibilities for diversification do not reside only in the choice between stocks and bonds, but also in possible investments abroad , especially if the reference horizon is long and there is a need to have a varied and balanced portfolio.
FIRSTonline – Is it possible to train savers' minds to make rationality prevail over emotion or do we necessarily need an external consultant?
I will predict – I would propose a mixed solution. On the one hand, delegating everything to a consultant without having the slightest knowledge of what is happening can lead us to have a balanced portfolio, but it doesn't make us live well. It is therefore necessary to be aware of one's own tendencies and to inform oneself. On the other hand, however, we need to understand that trying to replace a consultant is wrong, we need to be more humble, recognize inexperience and knowingly get help. To have a healthy relationship with the counselor you need to be knowledgeable and do your part.
FIRSTonline – She studied in Italy and lives in the USA. Apart from the differences in the context, do you think the behavior of the American saver is different from the Italian one?
I will predict – If we talk about errors in investment strategies we can say that the sauces are different, the mechanisms are not. There are, however, some things that we should import from the United States such as the increased tendency to invest in equities. Pension savings are also highly developed in the USA, a sector in which 11 trillion dollars are invested.
Complementary pensions are not only additional insurance for our future, but they are also a huge investment opportunity, which allows for a bigger Stock Exchange, gives companies more opportunities to go public and has cascading benefits on the economy real.
One thing that we should never import from the USA is the unbridled propensity to consume. Based on the data, less than 50% of Americans have 3-5 thousand dollars saved, the propensity to save is minimal. A trend practically opposite to ours. We are more ants, they are more cicadas.
FIRSTonline – The Italian government is preparing to approve new regulations that will reward long-term investments (at least 5 years) compared to short-term investments on a fiscal level: what do you think?
I will predict – I like the idea a lot, it's a way of encouraging investments. If this policy manages to push citizens towards equity investments, it will be an excellent result. However, we must proceed very carefully, because the last thing we want is for a redistribution to occur from the investor to the fund. If this provision turns into a mechanism aimed at increasing the costs of the funds, it would not make sense. Using a macroeconomic perspective, as more resources are invested, the result should be the opposite, i.e. the cost of funds should go down.
FIRSTonline – Corporate welfare makes room for the renewal of trade union contracts: can it be the right way to encourage the development of supplementary pensions over simple wage increases?
I will predict – In principle it seems to me a good trend, but some distinctions must be made. The experience of American pension funds could also serve us. If the company replaces the salary increase with social security contributions, that's a good thing. In the USA there are guidelines on best practices for companies to follow, it is necessary to create automatisms and it would also be advisable for a government intervention to encourage companies to focus on supplementary pensions.
FIRSTonline – With regard to supplementary pensions, it appears to be a choice made by a minority of workers. What should be done to encourage it?
I will predict – Supplementary pension provision is a transfer of today's consumption to tomorrow's consumption. We need to make citizens understand that it is a necessary choice, we need to motivate them. To do this, two paths must be followed: the first concerns numbers. We need to raise awareness of the problem and make it clear how serious and real it is. Secondly, it is appropriate to exploit emotion.
FIRSTonline – Should the same emotionality that must be controlled regarding investments be instead used to push citizens towards supplementary pensions?
I will predict – Exactly. In the US we did an experiment: after a seminar on social security funds in which we provided all the necessary information on the subject, we asked those present to do an exercise, making them reflect on the need to save in the present in order to ensure a peaceful future. We asked them to imagine how it would feel to live on little or nothing. It was a simple exercise that however increased the propensity to save by 4%:
In addition, the most effective way to get supplementary pensions off the ground remains one: silent assent. With this automation, workers are enrolled in the pension plan with non-predefined rates and investments. If they do not want to join, they must notify the company. With tacit consent, participation rates in retirement plans are usually above 90%.
