Advisers must think beyond traditional risk profiling to understand how investors are likely to respond emotionally to volatility and which solutions they can realistically stay with over time, says Standard Life.
A new white paper by Standard Life and behavioural finance firm Oxford Risk finds that against a backdrop of heightened uncertainty and the FCA’s Consumer Duty placing greater emphasis on demonstrating genuine client benefit, the need to understand the full picture of an investor’s emotional as well as financial circumstances has never been more pressing.
According to the white paper, most investors fall short of their long-term goals not because they lack financial knowledge but because they struggle to maintain their investment strategy in the face of emotional discomfort.
Traditional portfolio construction has been centred on risk-adjusted returns, often focused on the assumption that investors are emotionally neutral and capable of withstanding volatility. However, a combination of fear, regret, uncertainty and doubt can impact investor behaviour.
The paper explores ‘anxiety-adjusted returns’ as a practical lens for understanding the outcomes investors can realistically achieve once the emotional costs of the investment journey are taken into account. It argues that rather than maximise expected returns, advisers and providers should focus on building portfolios that investors can confidently maintain through periods of market turbulence.
Dr Greg Davies, head of behavioural finance at Oxford Risk, said: “Suitability is not just about the risk an investor can afford financially; it is about the journey they can endure emotionally. Too often, those two things are treated as the same, and they are not.
“A technically optimised portfolio can still fail if the investor cannot live with the journey. Our behavioural fit to smoothing framework helps advisers identify where volatility is likely to become behaviourally costly, and where smoothing can provide useful emotional support. The goal is not to eliminate volatility. It is to help investors stay with a suitable long-term strategy in good times and bad.”
Central to the paper’s theory is investment smoothing, designed to reduce the visible peaks and troughs of portfolio values as markets move. While it is not a universal solution, for some investors it may offer a valuable buffer against the anxiety of volatility, the paper found.
Oxford Risk and Standard Life said advisers must go beyond demographics or a single risk score to consider an investor’s deeper behavioural traits; they must consider their composure under stress, their tendency towards impulsive decision making and their sense of financial security.
Mark Baldwin, head of smoothed managed funds at Standard Life, commented: “Taking a long-term view of investing requires understanding what causes investors to come off track, and volatility is one of the biggest threats to long-term outcomes because of how it can affect investor behaviour. Today’s white paper explores this further, highlighting that when people feel more confident through periods of uncertainty, they’re more likely to make good decisions and remain invested over the long term.
“In this context, smoothed funds can play an important role in helping investors stay the course. By stabilising portfolio values during volatile periods, they can provide the reassurance needed to remain committed to a long-term strategy and improve outcomes.”
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