ETFs: An Investor's Emotion Blocker
Much of the discussion about the attributes of exchange-traded funds (ETFs) focuses on their low cost, simplicity, transparency and practicality in gaining a desired degree of exposure to chosen markets for a diversified portfolio.
Another of the perhaps understated attributes of index-tracking ETFs – and traditional index funds for that matter - is their potential effectiveness as an emotion blocker.
Investors taking an index-investing approach to create at least the core of their deliberately diversified portfolios should be less inclined to let their emotions dictate any of their investment decisions.
Such investors should be less tempted to try to time the market, which is often motivated by concern or greed. The reality is that investors simply cannot expect to consistently pick the best times to sell or buy stocks.
In knowing that their low-cost, well-diversified portfolio is in place, investors have reason to feel more confident about concentrating on meeting their long-term goals in a disciplined, non-emotional way without being distracted by short-term market movements.
Australian investors are increasingly turning to index-tracking ETFs to provide the low-cost base or core to their portfolios.
These investors often adopt a core-satellite approach, investing the diversified core of their portfolios in index funds while holding smaller satellites of favoured actively-managed funds and direct investments, like shares in individual companies.
As Vanguard's Guide to core-satellite investing comments: "Core-satellite brings greater discipline and stability to an investment portfolio by reducing reliance on 'picking winners' or chasing fund manager returns."
Recent ASX statistics record the growing popularity of ETFs among Australian investors. The market capitalisation of locally-listed exchange traded products - most being index-tracking ETFs - has grown by 58 per cent over the past two years to more than $25 billion as at January 31, 2017.
Behavioural economists such as Daniel Kahneman of Princeton University, a Nobel Prize winner for economics, have long warned that investors are vulnerable to making irrational, wealth-destroying decisions - often driven by emotions. Kahneman warns about what he calls the "biases of intuition".
The creation of an indexed core for a diversified portfolio, using ETFs and/or traditional index funds, may help investors keep their less-desirable behavioural biases in check.
Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia.
As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment.