"It's important to recognize that most investors—sophisticated and unsophisticated alike—are 'wired' to make the wrong decisions consistently."

The Enemy Within

By John Bowen

You've seen your clients make the same mistakes over and over again: They don't take enough risk in their long-term investments. They panic and sell during a drop in the market. They chase returns by buying last year's winners.

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As a financial advisor, you can help prevent your clients from making these kinds of costly mistakes. In fact, doing so is one of the best ways to add value to your relationship. To be successful, you first must understand why your clients make the choices they do, and then help them to make better ones.

Explaining the Irrational

Behavioral finance provides insight into why clients so often make expensive mistakes—and then make them over and over again. The study of how psychology affects finance lays out some logical explanations for such otherwise irrational behavior.

In his comprehensive book, Beyond Fear and Greed, author Hersh Shefrin describes two types of common investor behavior. First, investors rely on rules of thumb, or judgments based on stereotypes. Second, investors are often more influenced by the form of an investment than its substance—something behaviorists call "framing." More often than not, investor mistakes can be attributed to one or both of these propensities.

Rules of thumb. Traditional finance assumes that investors will make objective decisions based on unbiased data. In contrast, behavioral finance asserts that investors often rely on rules of thumb to make their decisions. Because these rules of thumb may be inaccurate, investors end up making bad decisions.

The classic faulty rule of thumb is the belief that past performance is the best indicator of future performance. Subscribers to this fallacy are forever chasing hot funds in the mistaken belief that performance over a period as short as a year indicates that a fund manager is skilled, not lucky.

There are many other flawed rules of thumb: Large growth stocks will outperform small value stocks. Past losers will continue as losers. Strong past revenue growth means strong future revenue growth. Operating with rules of thumb like these makes it all but impossible to construct a wise portfolio (one based on sensible asset allocation, not manager selection) or to properly maintain it through periodic rebalancing (which often means selling winners and buying losers).

Investors who insist on following faulty rules of thumb can also become overconfident, another recipe for disaster. Perhaps the most common mistake overconfident investors make is simply trading too much. They believe they can pick the winners, and they pursue doing so vigorously. This is not unlike what happens in Las Vegas: Gamblers often believe they can beat the house through some system, and when they do win in the short term, they overestimate their abilities and take personal credit for their success.

Academic studies tell us, however, that frequent traders generally earn mediocre returns. One of the best studies was conducted by Brad Barber and Terrance Odean ("Trading Is Hazardous to Your Wealth," The Journal of Finance, April 2000), who looked at the trading histories of more than 66,000 investors over six years ending in 1996. They found that those that traded the most had the worst returns. In fact, the most active traders earned average annual returns of 11.4 percent, while the overall market return was 17.9 percent.

Why do investors engage in this kind of destructive behavior? People tend to search for evidence that confirms their beliefs, while disregarding any evidence to the contrary. These investors thought they did well because their accounts grew. They ignored how much more they could have earned if they had followed a simple buy-and-hold strategy.

Form over substance. Traditional finance assumes that all investors make their decisions using an objective risk-return analysis. Behavioral finance says that, in addition to these objective considerations, investors are highly influenced by how the problem is presented (or "framed") versus what the problem really is.

Behaviorists have found that people tend to be much more distressed about a loss than they are happy about the same amount of gain. Some researchers have concluded investors typically consider the loss of $1 twice as painful as the pleasure received from the gain of $1.

As a result, investors are willing to take more risks to avoid the pain of a loss than to ensure the pleasure of a gain. Faced with a sure gain, most investors are risk-averse. But faced with a sure loss, investors tend to become risk takers.

Research done by Daniel Kahneman and Amos Tversky illustrates this behavior. The researchers presented two groups of subjects with two different problems. The first group was given $1,000 and asked to choose either a sure gain of $500, or a 50 percent chance to gain $1,000 and a 50 percent chance to gain nothing. The second group was given $1,000 and asked to choose either a sure loss of $500, or a 50 percent chance to lose $1,000 and a 50 percent chance to lose nothing.

In the first group, 84 percent chose the sure gain of $500, while in the second group, only 31 percent chose the sure loss of $500. While the two problems offered basically the same net cash, the framing of the question caused the offers to be interpreted quite differently. (For more information, see "Prospect Theory: An Analysis of Decision Making Under Risk," Econometrica, 1979.)

One of the most common ways investors avoid the pain of loss is by simply refusing to sell losers. Rather than taking the loss and moving on, they hold on to a losing position endlessly, always hoping that it will bounce back to the price they originally paid. Behaviorists call this the "disposition effect." You may know it by a more familiar term: "get-evenitis."

Keeping Clients on Track

It's important to recognize that most investors—sophisticated and unsophisticated alike—are "wired" to make the wrong decisions consistently. And if you're completely honest with yourself, you'll probably recognize that you are also inclined, to some extent, to make these same mistakes.

Once you understand this, what are you going to do about it? One of the best services you can give your clients is guidance on how to avoid the mistakes they would otherwise make. Follow these simple guidelines to provide that important value:

1. Create a long-term plan—and stick with it. As part of your work with each client, you should develop an investment plan that will maximize the probability of achieving his or her most important financial goals. In fact, you should not agree to work with any investor who does not agree to work with you on this basis.

A plan should spell out the client's long-term needs, objectives and values; define risk tolerance; establish a time horizon; determine rate-of-return objectives; describe the asset classes and investment methodology that will be used; and establish a strategic implementation plan.

2. Educate your client. Every client meeting gives you an opportunity to point out some human tendencies that can lead to poor investing decisions.

In particular, caution clients about the role of regret in their decision-making. Let them know that, because all investments have risk, regret is inevitable at some point. Point out the tendency toward hindsight bias—the mistaken belief that there was something they could have done differently to ensure a better outcome. When clients understand this tendency, it is much easier for them to stay the course over the long run.

3. Look at the big picture. Always put performance in perspective. Individual investments should be examined not just in context of overall market returns, but also as part of the larger portfolio over time.

It can be useful to show your clients just how concentrated gains in the market actually are. According to data from Dimensional Fund Advisors, an investor who missed the best month in each calendar year over the past 80 years would have a drastically lower return than one who stayed invested throughout the period. Someone investing $1 in the S&P 500 from January 1926 through December 2003 would have $2,661.55 after 80 years. If he or she missed the best month of each year, the same investor would only have $3.62!

Looking at the big picture will help overcome your clients' tendency to look at events in isolation from one another, which in turn will help them remain invested over the long term. It also sets a key expectation: You may not have positive results to report at every quarterly meeting, but your clients will still be on track to achieve their financial goals.

4. Be in close touch. Few things are as effective in helping clients avoid mistakes than simply being in close contact with them. Without your reassuring presence, it's all too easy for clients to overreact to market events and make poor choices.

Your client communication should not be all about investment results, however. With today's technology, it's easy for you (and your clients) to monitor portfolios on a minute-by-minute basis. This kind of obsession isn't good for anyone. Instead, focus on the larger issue of long-term portfolio management and on the personal issues in clients' lives that affect their finances.

Your clients are human and will make human mistakes. By understanding where they are likely to go off track, you can systematically take the steps that will help them avoid pitfalls and achieve investing success.