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Stop panic trading with the IKEA effect

Psychological bias can have a big impact on investors’ behaviour in a crisis. But that doesn’t have to be a bad thing.

Here we go again. Another shocking global event triggers another flurry of crisis communication in financial services. Financial advisers and fund managers reach out to steady their clients with letters, emails and social media posts.

Has anyone ever measured the ROI of all their reactive communication? I don’t mean to sound cynical. It’s sound advice to stay hands-off when the markets tumble. But in the middle of a crisis, everyone – business pages, pundits, pub bores – starts shouting at once. Your message, no matter how sensible, can be lost in the noise.

Why the urge to sell is so strong

‘Fear’ is a simplistic label for the psychological biases that sit behind panic trading. Of these, one of the most powerful is what’s known as loss aversion. It isn’t just that losses hurt investors – it’s that the pain of that loss is more than twice as strong as the joy of an equivalent gain. What makes this worse is the snake-bite effect, when an investor smarting from a big loss shifts their portfolio to a less risky position. They might even stay out of the equity market for good.

Trying to stop investors giving in to this kind of pressure with an email or a social media post will always be an uphill struggle. Instead, we need to help them build their psychological defences during periods of relative calm. And one of the best ways to do this could be to draw on another powerful psychological bias.

The power of ownership

In 1980, economist Richard Thaler put a name on the positive bias we all have towards our own stuff. He called it the endowment effect. Got a tacky but treasured holiday souvenir that you wouldn’t give up for cash? That’s the endowment effect in action.

In 2012, three professors of business researching consumer behaviour went further. They coined the IKEA effect to describe the even greater sense of attachment people have towards things they not only own, but made themselves.

The IKEA effect happens because creating something makes us feel competent and in control of our lives. It’s why you’re a bit fonder of your Billy bookcase than its form or function can really justify.

Self-selecting changes investor behaviour

In 2021, a group of researchers (Amin Zokaei Ashtiani, Marc Oliver Rieger and David Stutz) set out to find whether the IKEA effect applied to investing. They asked 219 people to invest imaginary money in a pretend financial market. Half the group built their own portfolios, and half had one put together for them by an ‘adviser’.

The researchers deliberately ‘crashed’ the market a year into the study to see how the participants would react. In the advised group, 31% of participants dumped their high-volatility assets. But in the non-advised group, it was just 10%. This difference had a greater impact on behaviour than almost any other characteristic – including level of education, age or income.

The researchers concluded that the non-advised group valued their investments more because they’d had a hand in selecting them – which made them less likely to sell.

Harness the IKEA effect

The sense of ownership that people get from choosing their own investments might be useful. But, clearly, we can’t start pushing everyone towards DIY platforms. Here are three ways we could stimulate a sense of ownership in investors without encouraging unnecessary risk-taking:

1. Ask clients to take an investment survey

If clients had the chance to align their choices with their personal view of the world on ESG matters, their savings might take on a much greater level of personal significance.

2. Connect them with their stewardship responsibilities

Use a service like Redington’s Ada platform to understand how the voting activity of fund managers compares to client preferences. Sharing this insight could result in a much higher level of engagement – and ownership.

3. Give them the good news

Fund managers are great at sharing case studies with their institutional stakeholders – but how often does this content filter out to individuals? Tell people where their money is and what it’s doing – stop shutting them out of the conversation.

This article first appeared in Redington’s Investment Edge.