Investment Tips and Trading Insights From Wealthy Investors

Investment Tips 2022:

• The single most important factor for the super rich in determining how much net worth to invest at any given moment is ‘advice from professional financial advisors’, followed by personal experience in markets.
• The least important factors for investment decisions are fear of losses, advice from the media, and advice from a friend or family member.
• Wealthy investors also believe that high-momentum and high-investment-expenditure stocks are best to avoid, while high-profitability stocks yield higher returns for lower risk.
• Moreover, actively managed funds are popular among those with more than $1mn in investable assets, despite their historical record of lower average returns.
• Wealthy investors also are not afraid to invest a large portion of their portfolio into a single stock, even at the expense of diversification.

Investment Advice From the Wealthy Investor

Wealthy investors are under-represented in surveys but account for a disproportionate amount of financial market activity. In 2016, the top 1% held over half of stocks and mutual funds and 65% of financial securities owned by all US households. This group of investors is far more active in markets than the average household, so their insights and experience are valuable to a broader class of retail investors and researchers.

A 2021 Journal of Financial Economics paper surveys, in conjunction with UBS, 2,484 US individuals with at least $1mn of investable assets to document the wealthy’s financial beliefs and personal investment decisions. The results highlight the importance of financial advisors – how to find a good one and how profit from their skills – and the key drivers of portfolio risk, such as age and disaster risk.

The Surveys: How to Source Trading Secrets?

Two surveys, run in 2018, underpin the analysis. One asks questions in UBS’s quarterly survey of high-net-worth individuals. These focus on the determinants of equity positions in a respondent’s portfolio. For example, how important is age in determining the total percentage of your net worth that is currently invested in stocks – both in private businesses and publicly traded companies?

The second asks questions about investment funds and trading philosophies in a one-off survey of high-net-worth individuals, again conducted by UBS. For example, compared with a growth stock, do you expect a value stock to normally be more risky, as risky, or less risky over the next year? And do you expect it to have higher, similar or lower returns over the next year?

The questions asked in both surveys were previously used in multiple pilot tests of US adults. Some questions were removed that were irrelevant to wealthy individuals. And a few were added about relative wealth concerns, illiquid investments, the expected returns and risks of high-profitability and high-investment-expenditure stocks, and reasons for choosing to hold a concentrated equity position.

Respondents are grouped by certain characteristics (Table 1). Most are over 50, employed, have investable assets of between $1-2mn, and have a household income of over $250,000. From a portfolio allocation perspective, the average respondent is most heavily weighted in US equities.

How Do Wealthy Investors Choose Equity Allocations?

The authors begin by focusing on the fraction of respondents invested in equities, which is 94% of the sample. They ask 40 questions, one for each factor that may determine an individual’s equity position. They then rank the responses ordinally based on the percentage of respondents that said a factor was very or extremely important (Table 2).

The most important factors, across all four columns are:

• Advice from a professional financial advisor.
• Personal experience investing in the stock market.
• Experience of living through stock market returns.
• Rare disaster risk.
• The risk of illness or injury.

At least 20% of respondents list these as very important. Among those working, years left in employment is also a key determinant, with 26% citing it as very important.

The least important, or cited as very important by the fewest, is:

• Loss aversion.
• External habit.
• Illiquid non-equity investments.
• Advice from a friend, family member or acquaintance.
• The desire to become wealthier than other rich people.
• Advice from media.

Risk factors feature heavily on the list. The largest risk factor that determines equity allocations is risk of illness, but this is only important for those with assets less than $5mn – only 12% list it as very important if they have over $5mn in investable assets. Meanwhile, the least salient risks are labour income risk, equities as an inflation-hedge, home value risk and illiquid non-equity investment risk.

There are four expected return factors:

• Stock return momentum (i.e., low returns followed by more low returns).
• Stock market return mean-reversion (i.e., low returns followed by high returns).
• Expected stock returns lower than usual right now (i.e., expect returns to increase).
• Expected returns higher than usual right now.

Fewer respondents felt momentum was as important as mean reversion. And, following a 17% increase in S&P500 returns in the 12 months prior to the survey, more respondents felt expected returns were higher and was why they were investing more in equities.

Of the nine neoclassical factors, disaster risk had the most support among respondents. Covariance with the marginal utility of money (i.e., stock returns are lower when money is needed) is next, followed by long-run consumption risks. Consistent with the well-documented empirical failure of the CCAPM, the covariance with the marginal utility of consumption (i.e., concern that when spending is cut, the stock market will tend to drop) is least important.

Lastly, the authors include five miscellaneous factors that could be important:

• These are ‘rule of thumb’ (e.g., setting one’s stock allocation percentage equal to 100 minus one’s age or investing a third of one’s wealth in each of stocks, bonds, and real estate).
• ‘Stocks take too long to convert to cash in emergency’.
• ‘Need cash on hand for routine expenses’.
• ‘Stock market returns before I was born’.
• ‘Hard to sell PE shares’.

Interestingly, 19% say having cash is very important (and in an environment of rising interest rates, that is an investment tip we also give!). The other miscellaneous factors have no real importance.

Investing Tips: Is Diversification Important?

One of the least well-kept trading secrets is that diversifying your portfolio is essential to reduce risk. However, many of the survey respondents had over 10% of their net worth in a single stock. In this instance, standard portfolio choice theory predicts investors would decrease their total equity position because of a lack of diversification. This is not true in the survey: two-in-three say it has no effect on their total amount invested.

Why do some wealthy investors forgo the benefits of diversification? Around half state they believe this stock will provide higher returns on average, and 33% say it would provide lower risk. Most of these cited both. Meanwhile, 26% said they held more than 10% in a single stock because of a personal or family association, and 17% because of a lockup agreement.

Investor Insights: Higher Risk, Higher Return?

In the one-off survey, the authors focus on what they call the ‘cross-section of stock returns’. That is, what are respondents’ beliefs about well-established equity return anomalies: value, momentum, profitability, and investment?

The survey participants get the following definitions, and are then asked about their risks and expected returns:

• Value is a stock that has a low price relative to its company’s current profits.
• Growth is a stock that has a high price relative to its company’s current profits.
• Momentum is a stock whose price rose a lot over the past year relative to one whose price fell a lot over the past year.
• Profitability is a stock of a company with high current profits relative to one with low current profits.
• Investment is a stock of a company that currently has high investment expenditures relative one that currently has low investment expenditures.

The results show respondents are convinced that value stocks are less risky than growth stocks and offer lower returns in expectation. Those with $5mn+ in investable assets on average find value stocks to be good deals, with such stocks offering higher returns for less risk (Table 3).

High-momentum stocks, on the other hand, are seen as bad deals. More people believe such stocks are riskier and offer lower returns, despite historically these stocks offering higher returns than low-momentum stocks.

Beliefs about high-profitability stocks line up more with empirical evidence (high positive alphas). Respondents, especially those with $5mn+ in investable assets, feel such stocks offer higher expected returns with less risk. Beliefs regarding high-investment-expenditure stocks also make sense, that is, they are typically bad deals.

Active Investing vs Passive Investing

Active funds typically offer lower average returns, so is investing in an actively managed fund instead of an index fund a mistake? The authors ask survey participants (a) whether they have pursued an active investment strategy before and then (b) what factors persuaded them to invest in an active strategy over a passive one.

The results suggests that a significant amount of active investing through funds by the wealthy is driven by a belief that they can identify managers who will deliver superior unconditional average returns. To identify these managers, most agree that high past returns are the most important evidence of manager skill – a finding we have documented in other research. And, once such a manager is found, most expect higher average returns than a passive fund.

Bottom Line: What Can We Learn from the Wealthy Investor?

The paper shows the wealthy investor is similar to the average investor in many ways. Retirement, risk of illness and the need for cash on hand for routing expenses are particularly important drivers of where and when to invest. And, when investing, there is a clear consensus that listening to professionals is particularly important.

Then, on where to invest, the wealthy collectively believe that high-momentum stocks and high-investment-expenditure stocks are overpriced. Instead, high-profitability stocks, i.e., ones that are currently registering higher profits relative to the market, tend to be good deals. And do not disregard actively managed funds over passive funds – the rich believe skilful managers can be good value for money if you find the right one.

Note: Pitfalls of Surveys

Surveys are never idea sources of data. Respondents have no incentive to provide accurate responses, they are fraught with biases at an individual and study level, and the aggregate results may not reflect the true population.

Nevertheless, it is inherently interesting to know what individuals believe about themselves and the reasons for their behaviour. These individual perceptions will often affect how respondents forecast their future actions, which in itself is an input into their current actions.

So, while it is hard to determine the extent to which measurement errors and biases exist, the responses from the surveys are still informative. Just like studying billiards players won’t help us understand the laws of physics, despite players adhering to them, documenting the beliefs of investors may not help us uncover the mechanisms that drive markets. However, they are still important as long as they generate accurate predictions of current and future behaviour, which the authors argue they do.