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.