By Tony Davidow, CIMA
“Our comforting conviction that the world makes sense rests on a secure foundation: our almost unlimited ability to ignore our ignorance.”
― Daniel Kahneman, Thinking, Fast and Slow
Investors do not always act rationally. After all, we are only human, and we often respond emotionally to events. Most traditional finance theories assume that people do act rationally, considering all available information when they make investment decisions. Behavioral finance challenges that assumption and explores how individuals respond to stimuli.
Harry Markowitz, Bill Sharpe, and Eugene Fama won Nobel Prizes for their work in defining investment theory. Markowitz is generally recognized as the father of modern portfolio theory. Sharpe introduced us to the capital asset pricing model (CAPM), and Fama introduced the efficient market theory. Their research provides the foundation for how we invest today and has spawned numerous other studies and theories. These pioneers in modern finance used historical data to prove their theories. While these theories are highly instructive, they assume that investors make logical and rational choices.
The Human Brain
While many consider the Altair 8800 the first personal computer (1974), I would argue that the original personal computer is the human brain. It is capable of complex computations and has extended storage capacity. The human brain processes information in seconds and is capable of learning history, math, science, literature, philosophy, and the arts.
The human brain also processes all sorts of emotional stimuli, including fear, greed, euphoria, grief, pain, and pleasure. While the modern-day PC processes information in nanoseconds, in a logical and rational fashion, the human brain often responds to emotional stimuli in an irrational manner. Daniel Kahneman and Richard Thaler each were awarded Nobel Prizes for their research of behavioral finance, how the brain responds to certain stimuli, and the biases that we all exhibit. We now recognize many of the biases and understand how investors behave.
Common Behavioral Biases
- Loss aversion. Investors will go to great lengths to avoid losses. Consequently, they may fall short of their goals by being too conservative.
- Confirmation bias. People are often drawn to information or ideas that validate their beliefs and opinions. This bias can hurt investors, who should objectively evaluate a strategy or investment product.
- Mental accounting. This occurs when a person views some money sources as different from others—for instance, money you’ve earned versus money you inherited. Investors may also become emotionally invested in individual stocks or mutual funds.
- Illusion of control bias. This occurs when investors believe they can pick individual stocks or managers that will outperform. They believe that because they are in control, the outcome will be better.
- Recency bias. Many investors are prone to chasing hot stocks, asset classes, and asset managers. They see strong recent results and extrapolate those results into the future, which rarely works out in the long run.
- Hindsight bias. This occurs when investors say (after the fact) that they knew a particular stock or investment would fail. Both investors and advisors tend to overstate their abilities to predict the future, which can lead to excessive risk-taking.
- Herd mentality. Although many people pride themselves on thinking independently, humans are social animals and often do what others have done. Investors may chase popular stocks or managers for fear of missing out.
How to Become a Behavioral Coach
Wealth advisors provide valuable advice regarding a myriad of issues facing HNW investors. One of the most valuable roles they play is serving as a behavioral coach, helping investors deal with their irrational responses to changing market conditions. A behavioral coach is both a psychologist and teacher, diagnosing each client’s behavioral biases and educating them to avoid emotional responses.
Advisors need to see how each client responds to market shocks, failing to keep pace in rising markets, and long periods of uncertainty. Some clients become apprehensive at the first sign of market volatility and need constant reassurances that their portfolio is built to weather the shock. Others are more comfortable with elevated risk and are able to ride out volatility with little or no intervention. Advisors need to tailor the type, tone, and frequency of communication for each type of client. For the jittery client, frequent communication design to calm emotional impulses may be appropriate; but for the confident client, frequent communication may signal that they should be more concerned about the markets.
Becoming a behavioral coach needs to start well before a market shock. An advisor needs to establish credibility and gain the client’s respect beforehand by explaining how the markets work by balancing return and risk. Earning the client’s trust begins with the discovery process, by explaining why you are asking the questions and how you use their answers to build the appropriate portfolio for them. You are trying to ascertain the client’s ability to take risk (mathematically) and their willingness to take on risk (emotionally). They will not always match.
Vanguard has attempted to quantify an advisor’s alpha, breaking out such value-added elements as asset allocation, cost-effective implementation, rebalancing, asset location, and behavioral coaching. Their research estimates that in aggregate, an advisor can add roughly 300 basis points, with effective behavioral coaching adding 150 of those basis points. In other words, coaching is the biggest single source of value in an advisor relationship, representing about one-half of all of the value added. Intuitively, this makes sense, because we understand the cost of making irrational decisions and the value of keeping clients engaged when things feel the most uncomfortable.
What are the Right Questions to Ask?
To better understand how an investor really feels about the markets and the related risks, it is important to ask the right questions. Ask these questions during the initial discovery process, and revisit them periodically, especially during periods of high volatility.
- How did you feel during the March 2020 market volatility? Did you consider changes in your portfolio?
- How do you feel about your current asset allocation? Do you feel comfortable that you will achieve your long-term goals?
- What is more important to you: outperforming the market in rising markets or retaining your wealth in falling markets?
- What would do if your portfolio rose 10%? (increase equity allocation, decrease equity allocation, or keep the same allocation)
- What would you do if your portfolio fell 10%? (increase equity allocation, decrease equity allocation, or keep the same allocation)
- How do you define risk (in traditional financial measures or personal terms)?
- Which would you prefer: a portfolio with lower risk and lower return, or one with higher risk and higher return?
Wealth advisors should educate their clients about the financial markets, asset allocation, and behavioral finance. They should comfort clients by assuring them that they are not alone – we are all prone to responding to emotional stimuli – and should not shy away from recognizing the challenges we face in overcoming irrational impulses. Wealth advisors can add considerable value by embracing their role as a behavioral coach.
About the Author: Tony Davidow
Anthony B. Davidow, CIMA®, is president and founder of T. Davidow Consulting, LLC, an independent consulting firm serving the needs of sophisticated advisors, asset managers, and family offices. He is chair of the Investments & Wealth Monitor editorial advisory board. He earned a BBA in finance and investments from Bernard M. Baruch College. Contact him at firstname.lastname@example.org.
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