What financial advisors can learn from behavioral finance

The surge in volatility in the third quarter affected a wide range of assets and made a mockery of portfolio diversification — unless “diversification” meant a portfolio composed entirely of U.S. Treasury bonds. Spooked by ominous headlines from Europe, investors got a taste for the dark side of rising correlations, and many made drastic short–term changes in portfolios designed for long–term goals. Many financial advisors expressed feelings of guilt about not doing more for their clients, despite having constructed prudently diversified and valuation–observant portfolios.

To better understand the motivations behind recent investor behavior, Putnam invited Santa Clara University Behavioral Economist Meir Statman, to discuss his new book and blog, What Investors Really Want, which explores the motivations behind investors’ cognitive errors and emotional reactions to volatile markets. We asked Professor Statman about guilt, control, and what advisors can do to counsel their clients in times of great anxiety. Here are his thoughts:

Investors need to see the big picture
“We live in scary times. The conventional advice is to hold diversified portfolios for the long run, and everything will be fine. But things haven’t been fine for a long time. So people are confused and losing hope. It is very important that we regroup, reflect, and remind ourselves of what we know about the behavior of markets and the behavior of people.

Fear is a critical emotion we must understand if we are to guide investors. Fear is generally a useful emotion. Fear urges us to step back from the edge of a canyon, and fear urges us to step on the brake when the car in front of us suddenly stops. But fear misleads us when it magnifies the perception of risk beyond real risk and decreases risk tolerance beyond prudent risk tolerance. Fear compels many investors to take actions that are contrary to their long–term goals. Reason instructs us to expect high returns only when we take high risks and warns us against investments promising returns higher than their commensurate risks. But fear instructs us otherwise. Fearful investors perceive risk as higher than it is, and fearful investors expect returns to be abysmally low. Exuberance is at the other extreme from fear. Remember exuberant 1999, when investors perceived risk as lower than it was and expected returns to be high enough to get us to Dow 36000 in no time at all?

Investors regularly fail to consider the long history of the ups and downs of markets. Instead, investors focus on the most recent history of the market and its most vivid events. In other words, they extrapolate the trend of the markets from recent experience, and paint pictures of future markets as if they are identical to the current picture. The experience of 2008 is still most vivid in the minds of investors, its losses are still most painful, and the desire to not lose money remains much more powerful than the desire to accumulate additional wealth. In 2007, investors focused mostly on getting rich. Today they focus almost exclusively on not being poor.

Advisors know that the right way to study markets is over long periods, extending into many decades. But advisors must know that long–term perspectives do not come easily to their investing clients. Today’s markets present a great opportunity to educate investors and hold their hands. Investors would be grateful in time, even if not immediately, and this education and handholding would add to their trust in their advisors and their loyalty toward them.”

Advisor guilt is natural, but unproductive
“I spoke to a number of advisors in February 2009 who were understandably distressed. They were distressed not only because of what the decline in the market had done to the portfolios of their clients and their own portfolios, but also because they felt guilty for letting their clients down. They had told their clients that things would eventually be fine, but they were surely far from fine in early 2009. One advisor said he had told his clients that there had never been a 10-year period where stocks did not have a positive return. ‘What do I tell them now?’ he asked.

Turn away from thinking about a portfolio as having experienced one big loss, and turn toward thinking about a portfolio as a set of mental accounts dedicated to real goals, such as retirement income, children’s education, and bequests. For example, how much of the portfolio is there to help a client not be poor? How much is committed to helping a client feel rich? This is overly simplistic, but it lays the foundation for a constructive conversation (e.g., not that a client has lost 20% of his or her portfolio, but rather that he or she has temporarily lost some of the upside potential). That can make an important difference for clients, who can put their situation in the proper context and reach the right conclusions for wise actions: ‘I can still retire,’ ‘I can still help my children,’ and ‘I can still accomplish my other really important goals.’ In addition to providing context, it is important for advisors to help those clients who are focused on short–term losses re–imagine and redesign their portfolios to fit their goals.

An automobile accident provides a good example. If I, as the investor, get into an auto accident one day, then you as an advisor can ask me, ‘What was the extent of the damage? Yes, I know that the accident ruined your day, but was it a fender–bender? Does your car still run? Or was it a more serious accident, where someone got hurt, or worse?’ There are many gradations of damage and loss in car accidents, and investment accidents are no different. Sometimes, people need to make difficult choices as a result of portfolio losses caused by market downswings. Some must save more and spend less. Some must postpone retirement for a few years. For others, portfolio losses may mean hits to egos rather than to lifestyles. They are not as well–off as they used to be, but they can still live as well as they did.

The market inflicted a major accident on portfolios last quarter. Feeling guilt over clients’ distress is natural, but not particularly productive. Sometimes, we have to accept the things that are beyond our control and figure out the difference between things we can change and things we must adjust to. Surgery is distressing as well, but it can be the beginning of the road to better health.”

There is more than one way to give clients control
“Advisors often tell me that ‘just sit tight,’ simply doesn’t wash with clients who want to take action after experiencing a loss in their portfolios. What advisors need to recognize is that people who lack control try to compensate for it by imbuing their environment with order and action. This includes finding patterns in markets when none exist, adhering to superstitions and conspiracies.

Advisors manage both investments and investors. Indeed, managing investors is more difficult than managing investments, and perhaps more important. In this, good financial advisors are like good physicians. Both are on the frontiers of knowledge in their fields, whether finance or medicine. But both also must have good bedside manners if they are to fully help their clients or patients. Advisors, like physicians, must ask questions about what hurts, listen carefully, be empathetic in their responses, educate, and treat. Good advisors, like good physicians, guide clients to wise decisions, free of cognitive errors and misleading emotions.

Anxious clients are looking for control in turbulent times, and control often means action, whether wise or foolish. ‘Don’t just stand there,’ say clients, ‘do something!’ Incremental changes can satisfy the urge for action without driving them into foolish action. Dollar cost averaging is one example. There are many good arguments against dollar cost averaging as an investment strategy, but dollar cost averaging can be a wise strategy when frightened and despairing investors want to make drastic changes in their portfolios, such as selling all their stocks and replacing them with Treasury bills or gold. Slowing things down with dollar cost averaging can be a good idea. Making a move gradually over two years rather than precipitously in two days can be excellent advice. If clients insist on immediate action, it’s better to let them do something emotional on a small scale. Then, when they’ve had a chance to collect themselves, they’ll likely do something smarter.

The last thing to keep in mind is that people are hungry for investment education, and simply understanding more about the markets offers a sense of control. The fact that there is so much noise in the media about the best investments and investment strategies gives advisors the opportunity to play a critical role as trusted sources of information. Advisors can systematically show investors what is true and what is not true about investments and investment behavior, relying on systematic well–designed studies by academics and practitioners. Educating clients does more than give them perspective and a sense of control over volatile markets; it builds up a reserve of trust and respect for advisors, which will come in handy the next time the market sells off.”

The views and opinions expressed are those of Professor Meir Statman, Santa Clara University, are subject to change with market conditions, and are not meant as investment advice. Professor Statman is the Glenn Klimek Professor of Finance at the Leavy School of Business at Santa Clara Univerity. His research focuses on behavioral finance.