If advisors want to help clients during volatile markets and through an unpredictable future, elements of behavioral finance can explain decision making and describe an individual’s relationship with money, according to Virtus Investment Partners.
In “Three Money Principles to Thrive By,” a recent whitepaper, Virtus outlines three fundamental responses advisors can employ to manage their client’s emotions.
Behavioral finance helps to define a lot of the behaviors that advisors have witnessed from their clients for years, like a greater sensitivity to losses than to gains, an affinity for the most recent or most easily accessible information, and the desire to mimic others in hopes of grasping a portion of their success.
However, as a relatively nascent discipline, behavioral finance hasn’t yet offered very many practical solutions for advisors.
“Applicability is what I work on every day at Virtus,” said Brian Portnoy, director of investor education. “I wanted to summarize three key principles that drive a healthy and successful relationship with money.”
According to Virtus, three practical principles already present in many advisors’ planning processes help address client behaviors: risk management, diversification and behavioral modification.
Prioritize Risk Management
Risk management is necessary because of the long-term impacts of negative compounding. Clients may be guided by the realization that, after taking a 20 percent loss in their portfolio, it may take three to five years for average market returns to restore their net worth to previous levels -- and much longer if expectations for low or flat equity returns across the next decade hold true.
“When we think about money, we tend to think in terms of more: what can we make, and what’s the return going to be,” said Portnoy. “We tend not to think as clearly in terms of what we can lose.”
Risk management cannot be accomplished via a risk tolerance questionnaire and an asset allocation, Portnoy said.
There’s clearly an emotional component to risk management as it relates to loss aversion. In behavioral finance, loss aversion refers to the fact that “losses loom much larger in our psyches than gains.”
Researchers have estimated that losses are twice as impactful as gains -- in other words, a $100 loss is twice as painful as a $100 gain is pleasurable.
Left to their own devices, most investors would do better to focus on minimizing their regrets, not maximizing their potential returns.
Virtus argues that risk management is “actually more a mindset than algorithm” -- losses cannot be averted altogether, but investors can be prepared to recover quickly after the loss has occurred.
“If you’re building an investment framework that doesn’t have a clear conception of risk not just mathematically, but psychologically, you’re going to end up in a bad spot,” said Portnoy. “I don’t think the industry is where it needs to be on this topic.”
Embrace Diversification
In an era where some writers and analysts have declared diversification is dead, behavioral finance argues that a well-diversified portfolio is an effective method for preparing for the unpredictable future.
“The mathematics of diversification and the psychology of diversification are two different details,” said Portnoy. “You shouldn’t have to explain why it’s a bad idea to put all your eggs in one basket.”
Humans desire certainty and stability and have difficulty envisioning the cumulative ups and downs of the market over time, preferring to “see the future in an either/or frame” which leaves them in a search for a “sure thing” in the investing universe, according to Virtus.
Since a sure thing doesn’t exist, the next best solution for advisors is to diversify client portfolios in search optimizing, not maximizing gains – in other words, fulfill the client’s goals without overextending on risk.
Yet many clients have difficulty diversifying their portfolio in lieu of what they see as the highest returning asset class or the investment with the best potential moving forward. Portnoy points out that this tendency runs against the general principle of buying low and selling high.
“Because our old ways were focused on survival and any sense of danger that we feel is processed as a threat, we are wired with a deep bias of loss aversion to put more emotional value on what’s not working, rather than what is working,” said Portnoy. “The diversification conversation between advisors and clients is difficult and peculiar in ways that most people have never really articulated.”
Control Behavior
On a daily basis, investors are confronted by a huge amount of information, a portion of which often relates to their financial picture. Humans develop biases to help them sort through the large volumes of information for important details – but as these biases help reduce the amount of time it takes to collect and process information, they can also cause the omission of crucial data and lead to regrettable decision making.
“Our job is not really to beat the market, but to control ourselves,” said Portnoy. “Investors who end up in a good place tend to be aware of their emotions and capable of controlling hteir behavior.”
Biases may help explain why investors tend to buy and sell investments at inopportune times, causing them to underperform many of the funds and securities they hold.
Portnoy and Virtus list four emotional and cognitive biases that investors are prone to: overconfidence, confirmation, recency and mimicry.
In overconfidence, investors and advisors place a greater value on their own skills and opinions than is actually merited.
In confirmation, more emphasis is placed on already entrenched beliefs and decisions that are already made – information which confirms a client’s beliefs or decisions is accepted, while information which refutes their positions is rejected.
“Today, you can find any information you want to validate and confirm your belifes at any time,” said Portnoy. “As a result, that creates people and portfolios who are unwilling to change.
In recency, clients “overweight the relevance of information most recently seen,” according to Virtus.
In mimicry, clients uncritically mimic the decisions of others, like relatives or co-workers.
To help control financial behavior, advisors should focus on patient decision-making in the context of a plan. Tools like automation and implementing financial coaching can keep clients on the right path, said Portnoy.
“Relying on constant insights and emotional willpower is a lousy way to make an ongoing set of decisions,” said Portnoy. “If we can take all of our decisions about saving, investing and spending and automate them in accordance with sound principles, that’s a fantastic solution… just because something’s systematic doesn’t mean it won’t need to be implemented, monitored and evolved over time. If an advisor can take discretion away from human hands and put it in a more systematic program,” it potentially reduces the impacts of cognitive and behavioral bias.