Do investors act irrationally during periods of market gyration? You betcha.
“Financial planners and advisors face an especially challenging task in working with clients whose emotions and cognitive biases influence their behavior when faced with extended periods of boom or gloom.”
So said Kent Baker, Professor of Finance at American University in Bryn Mawr, PA., and Victor Ricciardi, Assistant Professor of Financial Management at Goucher College in Baltimore, MD., in their paper on behavioral finance in the Journal of Financial Planning.
Here are five irrational, puzzling, erratic, self-defeating, and understandable ways investors can potentially self-sabotage – and what advisors may be able to do to minimize the behaviors.
The Disposition Effect
Have you or your clients ever held on to losing stocks or funds too long? (“Acme Products is going to go up, I just know it, and they said so on TV!”)
According to Baker and Ricciardi: “Investors succumb to the disposition effect in which they tend to sell their winners too early, and hold on to their losers too long.”
But this doesn’t have to be your clients. “Financial professionals can play an important role in providing both financial and behavioral guidance in navigating within increasingly complex financial marketplace and helping investors from self-destructing if left to their own devices,” said Mr. Baker.
Similarly, do you have clients who hang onto a specific idea that affects future investment decisions? “When clients anchor on a bad investment decision, they can be very risk and loss averse,” said Mr. Ricciardi.
“Anchoring can result in both higher levels of worry and risk perception as well as lower risk tolerance, leading them to underinvest in stocks and overweight cash in their portfolios.”
Can advisors help clients toss the anchor?
If you’ve established a written investment policy guide with your client, the answer may indeed be yes. This is where the disciplined advisor may add value to your client, and to your client’s investment portfolio.
“Individuals tend to focus on downside risk when they invest in stocks,” the report said. “This feeling of loss can remain for an extended period.“
Not surprisingly, many investors who lost big during a market decline become allergic to stocks. A potential solution: discuss the benefits and drawbacks of alternative investments, real estate, bonds, and cash.
Do you know of anyone, whether it’s investors, sports anchors, or political pundits, who put more emphasis on what happened today or yesterday vs. what happened (and why) last year, or during the last decade, or golly wiz, back in the 1950s?
This is the recency effect. Some may call it “momentum.” Sometimes what happened most recently will happen next, and again and again. Or maybe not.
What are asset managers and advisors required to disclose on all performance-oriented literature? “Past performance does non guarantee future similar results.”
Focus on Outcomes
The takeaway? “Advisors need to remain disciplined even though their clients are not, “said Baker and Ricciardi. “By doing so, advisors can help their clients maintain a long-term focus instead of succumbing to short-term greed and fear.”
When faced with periods of market turbulence, you need to advise your clients to stay true to their plan – and to remain focused on their long-term goals, not on trying to time the market.
So this is the advisor value proposition: focus on client outcomes, not uncertain markets.
Is market turbulence impacting how you market your investment firm? For ideas on how to promote your firm in unstable times, try taking this 10-minute quiz: