Divider
Divider

John Bowen

The Enemy Within

Use behavioral finance to keep your clients — and yourself — from succumbing to "geteven-itis" and making other costly investment mistakes.

April 7, 2008
by John Bowen, Jr.

You've seen your clients make the same mistakes over and over again: They don't take enough risk in their long-term investments. They panic and sell during a drop in the market. They chase returns by buying last year's winners.

As a CPA and a financial advisor, you can help your clients avoid these kinds of costly mistakes. In fact, doing so is one of the best ways to add value to your relationship. To be successful, you first must understand why your clients make the choices they do, and then help them to make better ones.

Explaining the Irrational

Behavioral finance provides insight into why clients so often make expensive mistakes — and then redo again. The study of how psychology affects finance lays out some logical explanations for such otherwise irrational behavior.

Rules of thumb. Traditional finance assumes that investors will make objective decisions based on unbiased data. In contrast, behavioral finance asserts that investors often rely on rules of thumb to make their decisions. Because these rules of thumb may be inaccurate, investors end up making bad decisions.

The classic faulty rule-of-thumb is the belief that past performance is the best indicator of future performance. Subscribers to this fallacy are forever chasing hot funds in the mistaken belief that performance over a period as short as a year indicates that a fund manager is skilled, not lucky.There are many other flawed rules-of-thumb: Large growth stocks will outperform small value stocks. Past losers will continue as losers. Strong past revenue growth means strong future revenue growth. Operating with rules-of-thumb like these make it all but impossible to construct a wise portfolio (one based on sensible asset allocation, not manager selection) or to properly maintain it through periodic rebalancing (often means selling winners and buying losers).

Investors who insist on following faulty rules-of-thumb can also become overconfident, another recipe for disaster. Perhaps the most common mistake overconfident investors make is simply trading too much.

Form over substance. Traditional finance assumes that all investors make their decisions using an objective risk-return analysis. Behavioral finance says that, in addition to these objective considerations, investors are highly influenced by how the problem is presented (or "framed") versus what the problem really is.

Behaviorists have found that investors tend to exhibit more distress over a financial loss than joy over a gain of the same amount. Some researchers have concluded investors typically consider the loss of one dollar twice as painful as the pleasure received from the gain of one dollar.

As a result, your client-investors may be willing to take more risks to avoid the pain of a loss than to ensure the pleasure of a gain. Faced with a sure gain, most investors are risk-averse. But faced with a sure loss, investors tend to become risk takers.

One of the most common ways your client-investors can avoid the pain of loss is by simply refusing to sell losers. Rather than taking the loss and moving on, they can hold on to a losing position endlessly, always hoping that it will bounce back to the price they originally paid. Behaviorists call this the "disposition effect." You may know it by a more familiar
term: "get-evenitis."

Keeping Clients on Track

It's important to recognize that your client-investors are "wired" to make the wrong decisions consistently. And if you're completely honest with yourself, you'll probably recognize that you are also inclined, to some extent, to make these same mistakes.

Once you understand this, what are you going to do about it? One of the best services you can give your clients is guidance on how to avoid the mistakes they would otherwise make. Follow these simple guidelines to provide that important value:

  1. Create a long-term plan — and stick with it. As part of your work with each client, you should develop an investment plan that will maximize the probability of achieving his or her most important financial goals. In fact, you should not agree to work with any investor who does not agree to work with you on this basis.

    A plan should spell out the client's long-term needs, objectives and values; define risk tolerance; establish a time horizon; determine rate-of-return objectives; describe the asset classes and investment methodology that will be used; and establish a strategic implementation plan.
  2. Educate your client. Every client meeting gives you an opportunity to point out some human tendencies that can lead to poor investing decisions.

    In particular, caution clients about the role of regret in their decision-making. Let them know that, because all investments have risk, regret is inevitable at some point. Point out the tendency toward hindsight bias — the mistaken belief that there was something they could have done differently to ensure a better outcome. When clients understand this tendency, it is much easier for them to stay the course over the long run.
  3. Look at the big picture. Always put performance in perspective. Individual investments should be examined not just in context of overall market returns, but also as part of the larger portfolio over time.

    It can be useful to show your clients just how concentrated gains in the market actually are. According to data from Dimensional Fund Advisors, an investor who missed the best month in each calendar year over the past 80 years would have a drastically lower return than one who stayed invested throughout the period. Someone investing one dollar in the S&P 500 from January 1926 through December 2003 would have $2,661.55 after 80 years. If they missed the best month of each year, the same investor would only have $3.62!

    Looking at the big picture will help overcome your clients’ tendency to look at events in isolation from one another, which in turn will help them remain invested over the long term. It also sets a key expectation: You may not have positive results to report at every quarterly meeting, but your clients will still be on track to achieve their financial goals.
  4. Be in close touch. Few things are as effective in helping clients avoid mistakes than simply being in close contact with them. Without your reassuring presence, it's all too easy for clients to overreact to market events and make poor choices.

Your client communication should not be all about investment results, however. With today's technology, it's easy for you (and your clients) to monitor your portfolios on a minute-by-minute basis. This kind of obsession isn't good for anyone. Instead, focus on the larger issue of long-term portfolio management and on the personal issues in clients' lives that affect their finances.Your clients are human and will make human mistakes. By understanding where they are likely to go off track, you can systematically take the steps that will help them avoid pitfalls and achieve investing success.

Rate this article 5 (excellent) to 1 (poor).
Send your responses here.

John J. Bowen, Jr. is the Founder and CEO of CEG Worldwide, LLC, a leading research, publishing and consulting firm serving independent financial advisors, CPAs, insurance representatives and registered investment advisors. Download the latest research from CEG Worldwide or learn more about our coaching programs for financial advisors.