It has been said that the role of a financial advisor is not just to manage the client’s money, but also their behavior. Left to their own devices, investors will often run with the crowd and make poor investment choices, i.e. “shoot themselves in the foot.”
Numerous studies over the years by Dalbar and others indicate that the average investor in a mutual fund receives a lower return over a certain period of time than the return delivered by the fund itself over that same period. How is that possible? Timing the market, following the crowd, lack of patience, etc. – there are innumerable culprits.
Let’s take a moment to drill deeper. There is an emerging field in the investment world that many financial advisors are hearing more about called Behavioral Finance. Its origins are rooted in cognitive psychology which is the study of how people learn, what they know, and how they act on what they know. As the field evolves, it will focus on the decisions and choices people make and how those decisions are influenced. If we as financial advisors can help our clients recognize the reasons they make some of the choices they do, we can help them make better choices.
In 2002, Daniel Kahneman won the Nobel Prize in economics for work he did with Amos Tversky to develop behavioral finance. In 1979 they published a study of the powerful impact that aversion to loss has on people's decision making. One of the key findings was that the prospect of losses bothers investors much more than perspective gains please them. This highlights the two prevailing emotions that affect investor’s behavior, fear and greed. Their studies indicate that fear is more powerful. Thus, perhaps inadvertently, people understand the basic math at work here - a 50% loss hurts a portfolio much more than a 50% gain helps it. The two are not the same - i.e. a 50% loss requires a 100% gain to get back to where you were! Here’s a link to a video on our website that illustrates this point at the 5:10 mark: Bull vs Bear.
That is why we manage our advisory accounts the way we do. We want to do the best we can to help our clients avoid the devastating impact of large losses in their portfolio, particularly at or near retirement when large losses are most harmful.
As always, if you have any questions, please give us a call.
Until next time, cheers!
Jim