Behavioral Finance

As financial planners, we forge close personal relationships with our clients. But, as emotional as that can be, when it comes to our investment disciplines, we have ice in our veins.

We do not make investment decisions based upon fear, exuberance,  hunches, forecasts, or ill-informed opinions. This level of discipline is nearly impossible for the average investor to accomplish.

It is important for us to prevent our clients from acting out of fear in a financial panic. When asked, most investors admit that they have made costly mistakes in the past because they let their emotions get the better of them.

The data bears this out.  Annually compounded stock market returns from 1926 through 2015 as measured by the S&P 500 have been 10% per year.  A $10,000 investment at the beginning of the time period would have grown to to over $53 million by year end 2015.  Similarly, over the past thirty years the S&P 500 has returned 10.3% per year. No wonder that the U.S. stock market has been called the greatest generator of wealth in human history.

Yet, indications from any number of studies indicate that personal returns are lower than that.  Some of the shortfall is due to the fact that the S&P 500 index does not have any costs deducted,  while real investors are subject to costs.  Another factor is that few investors have their entire portfolio dedicated to equities;  most have some portion in fixed income securities to mitigate market risk.

However, the largest factor is the behavioral mistakes that investors make.  They trade on incomplete and inaccurate information. They are swayed by sensationalist media, and act on the opinions of their successful (and not so successful) friends. Despite knowing better, they give into the genetic tendency to get more of those things that give them pleasure: buy high — and get rid of things that cause them pain: sell low. Human beings are just wired that way.

Various studies have evaluated this tendency among investors and attempted to quantify the gap between investment returns and personal investor returns.    The results of Morningstar’s efforts in this area are discussed in their Mind the Gap 2016 article indicating average under performance of 1.13% annually.  The widely quoted Dalbar Annual Quantitative Analysis of Investor Behavior study appears to overstate the gap, citing 3.66% annual under performance. Either way you look at it mistakes are expensive.

The great majority (but not all) of our clients have avoided these behavioral mistakes. We devote a portion of every meeting to education and behavioral coaching. A behavioral coach can help clients to stay disciplined and be positioned to enjoy full market returns.

It is helpful to identify the destructive cognitive and emotional tendencies that are “hard wired” into the human psyche. As your wealth manager it is our role to save you from yourself; to prevent you from following these natural tendencies. The value of this behavioral coaching alone is significant.

A few of the more common tendencies and biases include:

The Recency Effect:

the tendency to emphasize recent experience too heavily.

When you fret over the short term performance of your accounts, you are making yourself a victim of the recency effect. An investor who looks at performance every day is going to find that about half of the days are up, and half are down. An investor who looks only at the monthly statement is still seeing more volatility and noise than anything else. It is not until we look long term that we see the great potential positive returns.

If when in the middle of a bear market you become convinced that the market will continue downward, you are a victim of the recency effect. Likewise if when in the middle of a bull market you become convinced that the market will continue upward, you are a victim.

Availability Bias:

the tendency to overweigh evidence that comes easily to mind.

When you find yourself being swayed by a prominent opinion or market forecast in the media, you are a victim of availability bias. When repeatedly exposed to a certain line of thinking, you are more likely to agree with it regardless of its merits.

More knowledge leads to more confidence, but not necessarily better results. For example, stock analysts who know so much about the companies they analyze have been shown to be no better at stock picking than a monkey is with a dartboard.

Gambler’s Fallacy:

the belief that deviations from expected behavior are likely to be evened out by opposite deviations in the future.

When you find yourself thinking: “The market has been rising all year; it is due for a correction” you are a victim of the gambler’s fallacy. When you think “this stock is so low, it can’t go lower!” you are likewise a victim.

The correct answer to a question may help: Knowing that when you flip a coin there is a 50% chance it will come up tails; if you flip a coin five times and it comes up heads all five times, what is the chance that on the sixth flip it will come up tails? The answer of course is 50%. The tendency is to think that tails are “due”. That is gambler’s fallacy.

Herding Instinct:

the hard wired tendency of social beings to find solace and protection in groups, and to conform to group behavior.

This is perhaps the most difficult emotional bias to overcome. Human beings have been conditioned from prehistory to seek protection in groups; it has been a matter of survival. Individuals who wander away from the safety of the group are vulnerable to predation.  To go along with the crowd is comfortable; to separate from the crowd is risky to the point of being painful. In fact research has shown that the pain of separation registers activity in the identical part of the brain affected by physical pain!

If you find that you have a burning desire to sell your investments because everyone else is selling, you are a victim of the herding instinct.

Recency effect, Availability bias, Gambler’s fallacy, and Herding instinct are not the only cognitive and emotional biases that adversely effect us; there are many more. A financial advisor who acts as a behavioral coach can develop disciplines and provide a steady hand to help you to avoid behavioral mistakes.

Improving investor behavior results in capturing higher portfolio returns; however, we believe behavioral coaching should be more than this. By utilizing helpful strategies and avoiding harmful biases in the context of your comprehensive financial plan we deliver value beyond that stated on your portfolio returns. This value can be measured by increasing net worth, reducing taxes, increasing your chances of success for accomplishing goals, and adding peace of mind. Read our “Quantifying the Value of an Excellent Financial Advisor” article to learn more.

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