Mari Adam is seeing a flood of the once-confident but now disillusioned do-it-yourself investors beat a hasty retreat to her Boca Raton, Fla., office. After a losing battle with the markets over the past 16 months or so, some want hand-holding. Some want to know what went wrong. Others want to surrender their portfolios to Adam for her expert management. So why isn't the president of Adam Financial Associates Inc. happier?
Because many clients, both existing and new, still don't quite get it. "I think clients learn, but they remember the very last lesson they learned, and they interpret it literally. For many that means: Don't invest in technology," says Adam. "The irony is the value managers they wanted to sell two years ago are the hot investment they're chasing now. And many of those value managers are investing in battered tech stocks."
Making life tougher for investors-who often are the slaves of their longest-running investment experience, in this case the wondrous bull market-is the fact that many still expect 20% returns. When they don't get it, they don't understand why they should pay advisors like Adam.
"I really think my experiences are typical. Sometimes, I'm talking to a client who's called asking for IPOs, and they'll say something that forces me to realize that they're totally clueless. They've been saying all the right things, but they still don't understand the first thing about the downside risks of the markets. And I realize that somewhere along the way, I must have failed to communicate reality to them."
Advisors across the country are experiencing the same challenges, but there is something they can do. Behavioral economists say that by understanding investor biases and the cognitive and emotional weaknesses that lead investors to make errors, advisors can create happier clients and more meaningful practices.
So what's wrong with investors today? Didn't the fact that the Nasdaq fell 69% from it's 2000 high as recently as March teach them the importance of diversification, risk-adjusted returns and needs-based planning? The answer, unfortunately, seems to be more no than yes.
Leading behavioral economists chalk up investors' cool reaction to the bearish stock market to the double whammy of overconfidence and optimism. "This causes them to overestimate their knowledge, underestimate risks and exaggerate their ability to control events," says Dr. Daniel Kahneman, a professor of psychology at Princeton University and one of the nation's leading investor-behavior researchers. "Worse, they're not as surprised as they should be when their guesses go wrong." Call it denial.
That's probably why Adam and other advisors still have clients who are determined to manage some portion of their assets themselves. Biases, says Kahneman and other researchers, create a strong disconnect between reality and perception. In this case, some investors are determined that they can still beat the law of averages and obtain above-market returns using their own investment prowess.
One of Adam's clients, who Adam says is not atypical of her client base, decided to continue managing two of her 10 household investment accounts when Adam refused to project long-term returns greater than 10%. "I said, 'I can't project you forward at 22%. It would be totally unprofessional.' And she told me angrily, 'If that's all you can do, I'll keep managing the accounts myself.'" Adam says. "I do sense that many will chase the next bubble out the door." And that's despite the fact that some clients who are managing some of their own money are down almost 100%, the planner adds.
Optimism can lead to success. "But it doesn't work well in gambling casinos," says Dr. Richard Zeckhauser, a professor of political economy at Harvard University. Unfortunately, a casino-like mentality underlies the way many investors invest, as a game of chance. "The odds aren't very good in Las Vegas either, but the casinos continue to be busy because gamblers and investors both have selective memories. They remember the big win but tend to minimize or forget the many losses they experience."
At the same time, many are prone, once they set their so-called investment plan in motion, to what Zeckhauser calls status quo bias. "Many people hold onto their assets and do not rebalance their portfolios, even when it makes investment and tax sense to do so," says the professor. He has conducted research that shows that if left a high-tech stock by a relative, most investors would opt to keep the stock rather than diversify into a balanced portfolio. The bias is strongest when investors use dollar cost averaging for buying investments, especially in retirement accounts.
Even in cases in which it makes sense to harvest tax losses, advisors are finding that some investors are loath to sell their losers. "I advised the same client who wants the 22% returns to sell a technology stock late last year to offset gains, but she refused," says Adam. "The decision wasn't rational. There was no indication that the price would move before she could buy it back. She had an emotional attachment to the stock. The lesson for me is even the most sophisticated clients are not as sophisticated as I think they are."
Indeed, almost all investors are prone to biases that can hold them back. But optimism and overconfidence seem to infuse most of them, says Dr. Terrance Odean, an associate professor of finance at the University of California. Odean has spent the past five years sifting through the investment activities of 78,000 investors nationwide, many handed to him by a large brokerage firm that has turned over the actual trading activity of all of its clients.
The findings? The Internet age and the long-running bull market have created a frenzy of overconfidence that is costing investors dearly. The more they trade, Odean found, the more overconfident they are. And the more overconfident they are, the more they trade.
These clients, more on the do-it-yourself side, but representative of those now harking to advisors' doors, turn over about 75% of their portfolio each year. Trading that frequently shaved about 3.7% off what the same investors could have earned in an index of AMEX, Nasdaq and NYSE stocks. The harder investors try, the poorer they do, Odean says. Really active households that trade up to 200% of their portfolio each year lag the above-mentioned index by more than 10 percent annually.
Men are on the losing side of this equation because they appear to possess greater doses of overconfidence than women investors. The academic found that men turn over their portfolios an average of 77%, while women trade an average of 55% of their portfolios annually. The extra aggression costs men an average of 1.4% annually, Odean says. The phenomenon is more pronounced in single men, who trade 67% more than single women and lag their performance by 2.3% annually.
Adding to the misery, Odean found when crunching the households' trades, is that investors left to their own devices trade down, rather than up-that is they sell their winners and keep their losers. In fact, the stocks they sold outperformed those they bought by 3.2% in the first year, and a whopping 8.6% after two years.
Of course, individual investors would have to crunch these numbers and confront the cold hard reality of their mistakes to learn from them. And that rarely happens, Odean says.
Why else would investors hang on to their losers? It's not so much an emotional attachment as it is a "regret-avoidance bias," he maintains. By avoiding the sale of losers, they avoid confronting the fact that they bought them in the first place and now must lock in their losses. They also avoid the potential that the stock might turn around in the future, after they've sold it.
The belief that one can beat the market is a sentiment that Odean understands far too well. He once held a seat on the Pacific Stock Exchange and worked for several years at a software company helping the president (a pal of his) pursue their mutually-shared belief-that they really could design a black box that would buy them above-market investment results. It never panned out. And today Odean says his research has "taken the fun out of most trades he might consider."
But it hasn't taken the wind out of investors' sails. They're still chasing hot money, says Dr. James Angel, an associate professor of finance at Georgetown University. "The stock market is a history of booms and busts and irrational investment behavior is by and large what creates both of them," Angel says. Some new technology or new discovery or new world will create the next bubble, he says. Some investors might be smarter, but there's always a new wave that won't have the experience of their own trial and error, which is one of the only ways that investors learn.
Advisors should take heart, though, that investing isn't the science it seemed to be in the past decade-when just about everyone could get it right, or imagine they had. More investors are beginning to need planning and advisory services, and, as their wealth and the complexity of things like tax management and retirement plan distribution set in, demographics will continue to work in advisors' favor, says Don Cassidy, a senior research analyst with Lipper Inc. "A few of us ran into a newer planner a few weeks ago and began trying to commiserate with him, but he stopped us and said: 'Actually, things are pretty good. Investors don't think they're as smart as they did a year ago.'"
Maybe there's a chink in their armor of overconfidence after all.