To say the least, financial markets were gut-wrenching for investors in 2011. An earthquake and tsunami in Japan, revolutions in the Middle East and North Africa, and unparalleled challenges to the Eurozone rattled nearly all asset classes and strained investor resolve. But the market volatility we witnessed in 2011 was relatively minor compared to what occurred in late 2008. As a result of these global shakeups, and those of the preceding decade, investors are unsettled about their investment practices, and are reacting to the unwelcome effects volatility can have on their emotions and investment returns.
What has been the psychological impact on investors across multiple generations during these bouts of volatility? And, why are investment strategies and risk tolerances so different from one generation to the next?
Function of age on risk tolerance
Investor reaction to two of the worst bear markets for stocks since the Great Depression is partly explained by age, according to a recent study conducted by the Investment Company Institute (ICI) and the Federal Reserve Board. It found only 22 percent of households headed by someone younger than 35 in 2010 were willing to take above-average or substantial investment risk, compared with 30 percent of such households in 1998.
Reduction in risk appetite is generally happening across the board, but most notably in the Generation Y cohort (investors younger than 35) — just when the need for higher returns is most urgent.
Investors who are now 50 to 60 years old were part of a great bull market that lasted 20 years. They made money in the markets through stock investments that rewarded them for taking risks. We now have Generations X (generally those ages 35-50) and Y who have never been actually rewarded for taking equity risk. As a result, we may have an unintended consequence of a large group of younger, risk-averse investors moving away from stocks at a time when most need the higher returns available from a healthy exposure to stocks over the long term. Increased tendencies toward loss aversion could cause many young investors to miss out on the returns necessary to meet their long-term financial goals.
Investment options for younger investors
A potential solution, especially for younger investors who may have watched their parents’ portfolios take a hit in recent years, could be taking small steps and gradually diversifying away from heavier bond or cash holdings and into stocks. Young investors may also find that company-sponsored retirement plans ― regarded by most workers as a pillar of financial security in later life ― offer gradual immersion into potentially more rewarding assets. More importantly, investors of all ages need to establish a clear and thoughtful financial plan that matches asset allocation to their objectives, time horizon and risk tolerance. A well-designed asset allocation strategy, implemented with thoughtful rebalancing, will allow investors to benefit from volatility.
Keeping emotions in check
Investors of any age who understand volatility are more likely to manage their portfolios with confidence and make effective decisions.
Volatility causes emotional distress, and that emotion can get in the way of making effective decisions about strategic asset allocation, which is one of the most important components of investment decision-making.
So what, then, can investors do to temper their emotions? Part of the answer lies in being able to acknowledge that human behavior has many layers. There are complex psychological reasons at play.
Human nature teaches us that fear is a powerful emotion and tends to overrule our rationality. Thus, in the case of extreme market volatility, investors will move in sync away from risk and toward safety. When they perceive that it is safe to get back into the market, investors get back in together, bidding up asset classes. These up-and-down market movements continue until economic conditions return to normal, or when someone or something steps in to restore order.
The key for investors is to separate the events in their lives from how they feel about their financial situation. Without drawing this distinction, emotions may lead investors to buy at the top and sell at the bottom. A professional advisor can be instrumental in helping investors create a financial plan that will allow them to better manage the emotional stress that comes with volatility. Additionally, investors need to recognize the importance of strategic asset allocation, remaining flexible in the face of rapidly shifting markets, and thoughtfully rebalancing portfolios during periods of market stress.
Like it or not, the future is in the hands of Generation Y, and in this turbulent economy, an increasing number of companies are trying to find productive ways to work with a generation that has been raised on technology, the Internet, and ushered through their younger years on a velvet pillow.
Chris Elliott, senior manager of recruiting for the Phoenix office of The Capital Group, a worldwide firm that manages corporate and individual investments through mutual funds, says Gen Y poses some intriguing issues that companies must meet head-on. Like its investments, companies take the long-term view on employees, and this can be perplexing to the instant-gratification mentality of Gen Y.
“The recent change in market conditions seems to be best understood by people who consume a lot of news — whether through the newspaper, online or on television,” Elliott says. “Those people have heard about many companies that are reducing staff or decreasing benefits and they recognize that this has an impact on job offers in our market. However, some of Gen Y does not tend to follow the news closely and, not having experienced an economic downturn in their adult lives, they do not recognize the impact it could have on the overall job market.”
Mike Seiden, president and CEO of Western International University, believes Gen Y, even in this economy, is much more savvy than some might believe.
“Don’t be fooled into thinking that the Yer is less concerned about money than previous generations,” he says. “They want to earn as much as they can and are more than willing to play prospective employers against each other. We’ve all seen employees who accepted a job offer and were scheduled to start on Monday, but didn’t show up because they got a better offer over the weekend. It’s really too early to tell how the current economic situation will pan out, but I don’t expect that too many new employees will lower their salary expectations because the economy is having problems.”
The changing economic winds have educators evaluating their methodology, as well.
“We need to recognize and integrate the needs of business with the innate skills of this generation,” says Ajay Vinze, the Davis Distinguished Professor of Business and director of the Executive MBA Program at the W.P. Carey School of Business at Arizona State University. “With Gen Y, technology is part-and-parcel with their existence. They see their cell phones and the Internet, and see the world and how they can make an impact.”
The education experience remains key to ensuring Gen Yers — no matter the economy — are ready to hit the ground running when they enter the work force. Gen Y is adept at working in a team environment and likes clear expectations and goals outlined for them.
“Our task is to keep track of the characteristics and skill sets of what employers are looking for and translate that into our teaching,” says Barbara Keats, an associate professor of management at W.P. Carey. Keats adds that the school continues to see Gen Y students struggling with some fundamental communications skills.
“They have the knowledge, they just need to be shown some strategies to communicate,” she says.
Still, what remains are some underlining factors employers should think about with Gen Y.
“I believe there is absolutely more of a sense of entitlement in this generation than in older generations,” Seiden says. “They expect they will be treated with respect, rewarded whenever they do a good job, have opportunities to advance as rapidly as they think they deserve to and will have the flexibility to live as they choose with little or no interference from the company in their lifestyles.”
While some, like Seiden, say Gen Y has a strong sense of entitlement, Vinze isn’t so sure that’s really the case. In fact, he says, the eagerness and hyper-urge to get things done can make Millennials productive workers from day one. They like to create new titles as a sense of empowerment, such as chief knowledge officer or chief innovator. This shouldn’t be taken as entitlement, Vinze says.
What could be a big plus in this economic slowdown is Gen Y’s ability to multitask and seek creative solutions to everyday problems, adds Julie Smith David, an associate professor at W.P. Carey.
Gen Y is also interested in working with older employees who can serve as mentors and foster the capabilities of this future generation of leaders.
“My take-away is both older workers and Gen Y have a lot to learn from each other,” Smith David says. Seiden addsthat companies should remain flexible with this “new gen” and realize the old thinking of yesterday does not necessarily apply today.
“This may include such things as flexible work hours and telecommuting,” he says. “Gen Yers want to be challenged. They want assignments that will allow them to ‘show their stuff’ and gain recognition, so providing job opportunities that allow them to do so are important. They want assignments that are challenging, but they want to be trained and provided the tools with which to complete those assignments. Company image is important to them. There appears to be more of an emphasis on working for a good, socially responsible corporate citizen.”