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Investment Behavior: How to Help Clients Steer Clear of Irrational Decisions

By Simon Hassan, CFP, New Zealand

It’s a real challenge protecting clients and ourselves from natural “thinking mistakes”.

Behavioral economics has drawn our attention to the fact that the central assumption of traditional economics – that we behave rationally, often fails to hold. The truth is that we are ‘hard wired’ by evolution to behave irrationally in many situations. Left unchecked, this tendency can lead to wrong decisions at crucial times.

Perhaps more than any other financial planning area, investing mistakes can have the most devastating consequences for a client’s wealth. Here are some of the traps and ideas about how we can steer clear of them.

Anchoring Information

Human beings are naturally inclined to attach too much significance to irrelevant starting points. For example if an investment a client purchased for $20 has fallen to $5 he or she tends to be reluctant to sell – even if the signs are that it will head lower yet.

When clients refer to past values we need to emphasize (again and again) good investment decisions are always about present and likely future values and cash flows, which have very little to do with what may have happened in the past.

Loss Aversion and Risk Taking

People hold on to investment gains and are quite disinclined to sell losers, hoping to recover (and surpass) their original position. So they tend to sell winners, and hold onto losers.

We can counter this by adopting disciplined and forward-looking asset allocation and security selection strategies. This helps force our thinking towards rational and away from emotional frameworks.

Over-Optimism

Evidence, like that in Figure 1, shows market variability and how long it can take to achieve positive returns after experiencing periods with significant volatility and negative returns. And yet we human beings – including experienced financial advisers – have a stubborn tendency to think we’ll do better than average.

To address this, we need to be sure we look at this sort of data – and show it to clients – frequently. We should use risk profiling discussions to explain the implications of seeking higher returns from higher risk strategies, and repeat this process at ongoing reviews.

Investment risk profiling firm Finametrica (www.riskprofiling.com) has produced sobering research showing that as risk profile rises the probability of achieving expected returns falls: well worth a look.

Another way to counter over-optimism is to focus on what will happen if actual returns are lower than expected, or if the sequence of actual returns works against the investor (as clearly explained by Michael Kitces at a recent conference in New Zealand, lower than average returns early on negatively impact long-term outcomes, even if overall average returns are as expected).

To take account of risks like this we need to focus projections on what would happen if clients live longer than their statistical ‘life expectancy’, and if returns are at the low end rather than the middle of the ranges suggested by research. So rather than focusing on high-end returns, as shown on the graph in Figure 2, we should consider using graphs without the green line (high-end) in them when explaining potential outcomes to a client.

Framing

People tend to be heavily influenced by the way information is presented. As Taylor Liao says, fund managers often take advantage of our ‘willing blind spots’: focusing on positive results and reasons things could turn out well.

We can address this by placing less emphasis on the sometimes overly-positive marketing material produced by fund managers, and doing our best to present bad news as well as good news.

Overweighting the Recent Past

People tend to believe recent patterns will continue. After one good period we expect another. After a bad period we expect worse. In reality – all other things being equal – the higher the return over one period, the less likely you are to get a high return the following period.

We need to remind ourselves and our clients that a good investment approach must be disciplined and may be counter-intuitive at times: following the crowd, especially when our old enemies Fear and Greed are out in front, usually means getting carried away.

Comfort from Statistics

Finally, people are also prone to taking too much comfort from statistics. Figure 3 shows the annual returns from the S&P 500 over the past 85 years to the end of 2012. The average annual return over this period was 11.3% per annum, with positive returns (the blue bars) in 72% of those years. But this is the simple or ‘arithmetic’ average (the result founded by adding all the annual returns and dividing by 85). However, the results actually achieved by long-term investors are not simple averages but compound (or ‘geometrical’) averages. Over this same period the compound average return from the S&P 500 was 9.3% per annum. Still pretty comforting, on the face of it. Especially when compared to 3.6% per annum – the result for an investor staying in 3 month Treasury Bills over the same 85 years. The difference of 5.7% per annum is the S&P 500 ‘risk premium’, the ‘reward’ for the extra risk taken by those who invest in shares.

Of course this comparison ignores some other important components: tax, costs, and inflation. Tax has more impact on the returns from Treasury Bills than on share market returns, but costs are higher for those investing in the share market. So let’s assume overall difference – the ‘risk premium’ – is not much changed by tax and costs. But the impact of inflation is vital. Over the past 85 years US inflation averaged 3.1% per annum.  So inflation reduced the spending power of invested capital by almost as much as interest added each year for an investor in Treasury Bills – and tax would have meant that real returns were negative. The share market alternative looks pretty good by comparison.

But there are other problems with the comforting picture painted above. Most importantly investment returns DON’T actually fit the ‘bell shaped’ curve of a statistical ‘normal distribution’. You can see this by comparing the green bell shape in Figure 3 with the bars representing the actual distribution. Of particular concern is the fact that where the actual results differ most from the ‘normal’ curve is to the extreme left – the lowest returns are a lot lower than simple statistics would lead you to expect. This kind of pattern is typical of long-term investment returns, which can be prone to out-of-the-blue ‘black swan’ events leading to negative results.

The sobering message for share market investors wanting an increased risk buffer, is that they need to factor in extra downside risk – something few investors or advisers seem to do. Once again disciplined processes and conservative assumptions seem to be the key.

Conclusion

Financial planners need to watch the natural biases to which we and our clients are all susceptible. And as in the biblical story, most of us find it easier to see the speck in another person’s eye than the log in our own!

We have to become good at throwing the rational wet blanket over our natural over-optimism – and that of our clients. They’ll thank us in the long term – and we’re more likely to be around to hear the thanks!

Investment advisers take on awesome responsibilities for preserving and growing their clients’ wealth. The crucial first requirement for us here is to help them avoid wealth destroying mistakes. Sticking to disciplined asset allocation and security selection processes, adopting conservative assumptions, and developing systems and processes that force us to consider options that don’t come naturally are important ways to ensure we really add the value our clients expect. 

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