A whitepaper published by Caderat Grant, a US based advisory services firm, shares interesting insights on how advisers can practically understand and deal with the underlying motivations of clients and shows how behavioural finance insights can help them achieve better investing outcomes. It shows five established tenets of behavioural finance that will greatly add to understanding investors. These are loss aversion, anchoring, familiarity bias, herd behaviour and gamblers fallacy.
For advisors, this finding has several implications. People honestly respond to questions asked in risk tolerance questionnaires but experience demonstrates that they act and feel quite differently when an actual market downturn occurs and the value of their holdings decline. Loss aversion can lead to investing behaviour that is sometimes irrationally risky and at other times irrationally risk averse. When investors are shaken by a dramatic market decline, for instance, they may become so frightened that they decide to sell all or most of their holdings. At other times or in other situations, they may be so frightened of loss that they hold onto investments that they deem safe, even if buying seemingly “riskier” investments would be less risky.
What can you do: First, use every client contact opportunity to reiterate your commitment to your client’s long-term financial health and meeting their goals. Next, tell clients that as part of your responsibility as their adviser, you have an obligation to bring risks to their attention that they may consider unpleasant. Clients must be continually reminded, however, that stock prices can go down, as well as up, regardless of positive economic forecasts or the projections of market.
One way to initiate a client conversation about loss would be to say, “Let’s suppose we saw prices start to fall – not just those one- or two-day events we’ve seen after which prices rebound – but maybe a big one-day decline that keeps on going. Let’s talk about how you would feel about the impact of such a decline on reaching your financial goals. In fact, what would you feel like right now if your portfolio was worth 10% less tomorrow? Would you be willing to take some steps now that might cut into present gains to position your portfolio for possible losses?”
The honest answers to these questions can prepare clients for what may come as well as afford advisers an opportunity to explain various investment products and strategies that can help mitigate loss. A discussion of loss and its impact also helps focus investors on their long-term goals and away from current performance. When investors are on track to meet those goals, any short-term declines are more likely to be seen as an expected hiccup rather than as a catastrophe.
Anchoring involves the human tendency to focus on one piece of information — usually the first piece offered — when making a decision. Because of this tendency, and because people have difficulty in assessing probabilities, many of the assumptions investors make about securities prices and the direction of those prices can be flawed.
What can you do: As their adviser, you have an obligation to bring risks to their attention that they may consider unpleasant. The key to avoiding problems with anchoring is to tie the purchase of mutual funds to a purpose. In the case of mutual funds bought to execute an asset allocation plan, decisions to buy or sell become more about updating positions to bring allocations in line with plan goals and less about having to sell securities that the investor might otherwise think of as being “temporarily” away from their “real” values.
It is a human tendency to describe our rule-of-thumb way of making judgments — to come to certain decisions quickly based on experience. When confronting a new situation or set of facts, our minds race to find similarities to past events and then come up with a conclusion or assessment of the current situation. All too often, however, this familiarity bias can lead investors astray.
For example, many investors tend to favour equities over fixed-income securities or energy stocks over technology stocks, for example, largely because they are comfortable with their current choices and find unfamiliar investments unsettling.
What can you do: Advisers should use the power of metaphors and stories to help their clients become familiar and more comfortable with different types of investments. Fixed-income investors anxious about the risks of equities should be told about quality dividend-paying stocks, which can be explained as being very bond-like in their return patterns. Similarly, growth stock investors who are comfortable assuming investment risk may wish to learn more about certain high-yield and distressed debt investments, which can exhibit growth-stock like volatility.
Herd buying or selling can be injurious to financial health. Many investors join mini herds and demand the latest or hot mutual fund. When prices break, other investors will join a herd of sellers.
What can you do: The best way for advisers to help clients steer clear of the herd is to educate and remind them that understanding valuations and paying and receiving a reasonable price for a security based on value are the most likely routes to success as an investor over the long run. Determining a fair multiple on a stock before buying or selling can help strengthen investors’ resolve and fortitude when running with the herd is enticing.
Tell clients that if ever several of their friends are buying or talking about a security, they should alert you before making any buying decisions so that you can do special research for them.
Let’s say you are doing a coin toss and you come up with heads six times in a row. It’s more likely that you’ll get fewer heads the longer you keep going, right? If your clients believe that, they are succumbing to the gambler’s fallacy, also known as the Monte Carlo fallacy. The fallacy is that a past pattern somehow influences future odds. Because humans have difficulty understanding the mathematics of probability, we are prone to seeing patterns in random events and then, after presuming a pattern, assuming that it cannot continue. Those who think “this stock is down so much it’s bound to go up” are expressing the fallacy.
The fallacy is that a past pattern somehow influences future odds. Because humans have difficulty understanding the mathematics of probability, we are prone to seeing patterns in random events and then, after presuming a pattern, assuming that it cannot continue. Those who think “this stock is down so much it’s bound to go up” are expressing the fallacy.
What you can do: Advisers are unlikely to persuade an investor that gambler fantasy market predictions are irrational simply by providing a lesson in statistics. Better to constantly remind clients that every day is a new day in the markets and that pricing direction in the short run is largely random. Also effective is keeping investors focused on long-term investing and discussing how they are making progress toward their goals. Those are the best ways to keep short-term market fluctuations from derailing their plans.
As in the mental accounting example, if clients cannot resist playing hunches on the market and falling victim to the gambler’s fallacy, it may be prudent to set aside a small portion of a portfolio for speculation.
Reproduced verbatim based on the whitepaper ‘Principles that fuel your clients.’ Click here to download the whitepaper.