Behavioural finance - understanding your clients' emotions

An understanding of your clients' emotions throughout the market cycle will help you maintain their focus on their long-term investment goals and minimise the 'behaviour gap'.

Most people recognise a balanced diet and exercise is key to good health. Likewise, most of your clients understand the principles of sound investing – principles such as diversification, having long-term financial goals and being prepared to readjust or rebalance their portfolio based on performance and life stages. Unfortunately, history has demonstrated that investors often perform much worse than they would have if they had stuck to these text-book principles.

Of course, it may be the case that your clients' circumstances have changed, forcing them to adjust their financial goals. However, your clients are also susceptible to a range of human emotions and innate behavioural biases which affect rational investment decisions – decisions that are ultimately destructive to their financial health. 

As a financial planner, you're the expert in financial products and markets, but beyond that what opportunities are there to engage with your client – particularly those who lose motivation or sight of their investment goals? Understanding the behavioural biases that affect your clients' decision-making provides one such opportunity – even an obligation – to engage with your clients more often. 

So what are some of the common financial behaviours and emotions and what can you do to make them work for you?

Overconfidence

Let's start by asking a question – are you a better driver than half the drivers on the road? 

Probably your answer is yes, and if you asked your clients the same question, they would give the same answer. 

From an economic perspective, overconfidence combined with your clients' natural competitiveness can seduce them into thinking they can regularly outperform the market. However, if their money is invested in a passive index fund then by definition they are doing nothing to outperform the market. For outperformance, they believe they must be active investors – they must be doing something!

This leads overconfident investors to trade stocks, change funds or jump between asset classes at an irrationally high rate. However, numerous studies have found that the most active investors (the top 20 per cent or 25 per cent by portfolio turnover), significantly underperform over time the least active investors (bottom 20 per cent or 25 per cent).

As well the predictable costs of trading fees and commissions, another problem for overconfident investors is that their investment choices are often based on another behavioural bias – herding – where your clients chase the next 'hot' asset class or stock (dotcom, property etc), sometimes relying on cherry-picked information or information completely irrelevant to sound investment fundamentals. 

As a financial planner you play an important role in keeping your clients calm and in many cases, doing the research on their behalf.

 If overconfidence and excessive trading causes a portfolio to lose, say, 3 per cent of its value, what value would they place on a financial planner who can counsel against their trading?

And remember your clients' inclination towards self-attribution bias – that is when an investment goes well they are likely to attribute it to skill, but when things go badly – well, that's bad luck!

Loss aversion

Loss aversion, simply put, is the idea that the pain of losing an amount of money is felt more acutely than the pleasure of making that same amount of money. Practically, this means your client, perhaps due to pride, who loses money on an investment will be less inclined to sell it (thereby crystallising that loss) than if they made money.

Conversely, if an investment does well investors are happy to sell for the emotional satisfaction of locking in a profit. Ironically, this leads clients to sell winning stocks and keep losing stocks, leaving investors with an underperforming portfolio and ultimately diminishing their returns.

For you there is an opportunity to influence your client based on the prospect of a recovery or if they should cut their losses on unprofitable trades, ultimately guiding them towards a stronger investment portfolio.

How can loss aversion be mitigated? Studies have shown that if an investor puts all their money into an investment at one time, their point of reference for whether this has been a successful investment is very clear. However, if they make regular contributions their point of reference becomes fuzzy and subsequently their loss aversion decreases.

Another behavioural trait – a variation on loss aversion – is endowment bias. Endowment bias – or the status-quo bias – says that once you own something it is more valuable to you than what you (or someone else) would be prepared to pay to acquire it in the first place - for example, inheriting an underperforming share portfolio, but not selling because your parents owned them.

Inertia

For any investment, there is a prospect of a future loss. This fear can drive inertia or procrastination, however regret avoidance or the 'wait-and-see' approach isn't the only reason why people don't invest. 

Another cause for inertia is an every-day behavioural bias you see at the supermarket. The more choices you have, not only does it take longer to make a decision, but the more likely it is that the decision will be random and uninformed. Alternatively, some investors will want to study their investment options closely but then find it too much to understand to make an informed decision.

The result of inertia, whatever the cause, is that your clients' cash holdings are virtually guaranteed to underperform a well-diversified portfolio. 

How can you help you break your clients out of their inertia? Or make inertia work for them? 

Firstly, have your clients pre-commit to investing. Also give your clients the choice to opt-out at any time, because as the status-quo bias shows, you know they rarely do.

Secondly, have your clients commit to investing at regular intervals, ideally before their money reaches their bank account. 

Whilst, subconsciously, behavioural biases can't be cured, an understanding of your clients' emotions throughout the market cycle will help you maintain their focus on their long-term investment goals and minimise the 'behaviour gap' that commonly sees investors' portfolio underperform the broader market.

 

What's your experience of behavioural economics?

Important
The information contained in this newsletter is provided on behalf of the IOOF group of companies and is intended for financial adviser use only. It is given in good faith and has been prepared based on information that is believed to be accurate and reliable at the time of publication. Any examples are for illustration purposes only and are based on the continuance of present laws and our interpretation of them at the time.