Are clients rational? Harold Evensky, a leader in the financial community, says the answer is “resoundingly no.”
That is the reality that advisors have to deal with, and try to correct, he explained during a webinar Wednesday sponsored by the Society of Financial Service Professionals.
Evensky, president of Evensky & Katz Wealth Management in Coral Gables, Fla., and Lubbock, Texas, says advisors need to know how to persuade their clients to make rational decisions by framing the discussions in a way that promotes good decision-making.
“If a client wants to invest a large portion of their portfolio in a hot tip they received, ask them to explain what the company does and what could go wrong. Let them frame the possibilities, rather than you doing it,” he says.
There are a number of pitfalls that advisors need to be aware of so they can guide clients, he adds. For instance, clients tend to make simple mathematical mistakes that lead to bad investment decisions.
If a client makes an 80 percent profit one year and loses 60 percent the next year, he thinks he still has a 20 percent profit; but he doesn’t. If a client loses 50 percent one year and gains 50 percent the next he is not back to being even, he has lost money. An advisor may have to explain that to a client.
Likewise, if a client is 90 percent sure a series of events will occur to make a stock profitable, that does not mean the stock has a 90 percent chance of success. If you are trying to predict linked events, you have to multiply the probabilities and you may end up with only a 60 percent chance of success.
People by nature are overconfident and think they can do things better than others, including picking the best stocks. Advisors need to point out that everyone cannot be the best.
Advisors also will want to get clients to understand their expectations by rating the importance of capital preservation, growth, inflation protection and cash flow. Clients need to know the importance of being invested for long-term results.
“If you invest today and the stock goes down tomorrow, it does not matter because you are not going to sell,” says Evensky.