Are there ways to prevent clients from acting on self-defeating impulses and faulty thinking? Look to the fascinating findings of behavioral finance.
Apart from higher returns, investors seek other payoffs: enhanced self-esteem, and feelings of hope and exuberance, for example. But this often leads to their making the wrong financial decisions. Similarly, they can be impeded by negative emotions such as fear and despair, and by cognitive errors, like overconfidence and hindsight.
In his new book, What Investors Really Want (McGraw-Hill), Meir Statman, Santa Clara University professor of finance and behavioral finance researcher, provides deep insight into just what drives investor decisions.
A consultant to money management companies and brokerages, such as Merrill Lynch and Russell Investments, Statman, 63, educates clients and helps design diversified portfolios.
Science is the route to smarter investing, says Statman, who’s also a visiting professor at Tilburg University in the Netherlands. He urges FAs to deter clients from “the tempting voice of wants” — often prompting bad investment choices — and steer them instead toward “shoulds” — which mostly lead to smart choices.
Research recently interviewed Statman — recipient of two IMCA Journal awards, three Graham and Dodd awards and the Moskowitz Prize for best paper on socially responsible investing — to shed further light on how advisors can use the science of behavioral finance to build client trust and add value. Here are excerpts from our illuminating conversation:
Research: How can advisors save clients from themselves?
Statman: Clients are their own worst enemies. They come to advisors to tell them when to buy and when to sell, and what to buy and what to sell. But that’s not what advisors can do — period. Advisors cannot beat the market. But they can prevent clients from doing really stupid things. If advisors have that kind of conversation with clients, both would benefit.
Do FAs, then, act in a parental role?
Yes. If investors cannot control themselves, the advisor has to be the one who provides control — with a gentle voice and a bit of humor: “You’ll have to listen to me because a lack of self-control is going to do you in, and you’ll regret acting with haste. I’m here to prevent that.” Clients will understand that the advisor isn’t being a dictator but, rather, a parent. That’s what fiduciary duty is about.
What’s the best way for advisors to deal with clients’ cognitive errors, that is, flawed thinking?
Present them with science: what we know from systematic studies and logic about investing.
What’s a good strategy with clients who overestimate their investing skill and think they know more than the advisor?
Tell them, “Here’s an advantage I have over you: I’ve already learned the lesson that I’m trying to teach you, which is that there are illusions, and they’re common. For example, we remember our gains and forget our losses. I’m trying to teach you science so that you can make informed decisions.”
We know that people who try to beat the market are more [often] beaten by it. If a client thinks they can tell where the stock market will go in the coming week, ask them to keep a log, and then check it after 30 weeks.
How should advisors handle clients who want to trade often?
Scientific studies show that people who trade more, sacrifice returns and utilitarian benefits. If you show clients that trading actually reduces returns, maybe they’ll stop!
But you write that advisors shouldn’t tell investors to use reason vs. emotion. Don’t emotions lead to cognitive errors?
Investors should be mindful of their emotions. But emotions in investing aren’t always bad. Emotions reinforce learning rather than interfere with it. But you have to figure out when they get in your way.
If a client is fearful, advisors can tell them: “Fear is a natural emotion; but in financial markets, fear and its evil twin, exuberance, are going to mislead you. We know from science that fear decreases risk tolerance and increases risk aversion.” Then the advisor can point out: “I counter this by reminding myself that [in a down market], the world isn’t coming to an end. And when the time comes for real exuberance, I remind myself that the world isn’t going to be all roses.”
What if [clients are] fearful because they think the market will plunge and want to sell their stocks?
Tell them: “How about if we do this with dollar-cost averaging and get out of the market over a period of two years? And suppose we arrange that there has to be at least 10 days between the time you make a decision to buy a stock and when we execute it so that you’ll have a chance to cool off and reconsider? If it’s such a bargain, it’s likely to be a bargain in 10 days as well.”
What about anger? You write that angry people seek risk.
It’s not for nothing that our mothers taught us to count to 10 before we open our mouths when we’re angry — people who are angry are thoughtless. Anger is one emotion that drives investors to say, “I’m going to time the market”; that is, get out when stocks are high and get back when stocks are low.
When is taking risks generally a good thing?
It’s important for financial advisors to tell clients who are still young that risk-taking isn’t a luxury and that if they put all their money into Treasury bills, they’re going to live on very little in retirement.
Let’s say a client is feeling very sad, and this sadness is influencing her to make a bad investment decision?
Sadness causes people to want to get rid of investments. The advisor can refer to some of the studies in my book that support this. If people are sad and disgusted, and want out or want to do something rash, the advisor can delay it by saying, “Let’s talk about it next time we meet. Let’s give it some time because all of us are rattled by the market today.”
How should an advisor deal with clients who are overconfident about a specific investment they’re intent on making?
Say to them: “If you want to buy emerging markets because it will diversify your portfolio, go ahead. If you want to buy emerging markets because you’re confident they’re sure to go up, stop.” The question to ask whenever you’re buying is, “Who is the idiot on the other side of the trade? Is it possibly Goldman Sachs?” Also: “What do I know that isn’t known that’s going to give me an advantage relative to the person on the other side?”
TV broadcasters and their Wall Street guests get excited when the market goes up, leading viewers to believe that it must be the time to buy. What should FAs tell clients?
Individual investors tend to extrapolate from recent returns. If the market has been up, they think it will continue to do so; if it’s down, they think it will continue to go down. But we know from systematic studies, including my own, that the relationship is just the opposite and that when investors are bullish, markets are more likely to go down.
What advice should the advisor give in the above TV scenario?
Say: “When you heard someone on television [recommending] to buy such-and-such stock, who do you think was also listening to the same program? Who is taking advantage of this before you have a chance to? It’s possible that some people knew ahead of time that the person was going to say that and positioned themselves to profit from it.”
Please talk about the danger of hindsight.
Hindsight is most pernicious. If the client decides: “Don’t buy stocks on Mondays or those whose names begin with ‘A,’” they’re going to find that in hindsight, that rule worked or didn’t work — and they’ll think they found the rule, when in fact it was luck. Investment performance is so much luck and so little skill. People believe it’s in the opposite proportion. This is something advisors have to educate investors about.
You write that it isn’t wise to buy early into a revolutionary new industry. That’s so counterintuitive!
Again, the fundamental question is: Who else knows what you know? You have to take into account how good the prospects are for the new industry. It might have wonderful prospects. But in all [probability] everybody knows that, and the price is likely to be too high. Advisors should provide clients with evidence that buying early wasn’t a good idea with either the automobile or the Internet industries.
Still, many investors are looking for a thrill — the thrill of winning, of getting rich. Does the FA simply ignore that?
The advice that we academics provide feels like, “Eat spinach, never taste a cheesecake.” So advisors can say, “How about if we let you have 5 percent of your money to get thrills — just don’t get thrills with money you’ll need for retirement or your kids’ education.” It’s a matter of not prohibiting fun and games altogether, just that you need to have a balanced portfolio. As with a balanced meal, it cannot be all ice cream.
Financial advisors warn against mixing investments with patriotism, you point out. What’s the harm?
We have evidence that people who are [very] patriotic are more likely to restrict their investments to those in their own country, or at least tilt that way. This is taking away the benefits of diversification. It’s possible to persuade clients using logic: “If you want to show your patriotism, there are many ways that are useful and are actually going to do some good. You can volunteer at the Veterans [Administration] or make donations to organizations. But by concentrating your investments in the U.S., you’re not going to add anything to any veteran.”
This approach of trying to keep clients from making mistakes isn’t something that traditionally many, if not most, advisors have used.
If they haven’t, it’s about time! Some advisors are frustrated hedge fund managers. To them, clients are a nuisance — what they really like to do is pick stocks. Those advisors should quit the business. The role of the advisor is to advise, to guide, to help clients get to their financial goals.
That doesn’t mean you have to be a certified psychiatrist; but you need to find what the client wants, consider whether it’s reasonable to be achieved and show them how to get there — while all along the way, avoiding the problems of their misleading emotions and cognitive errors.
If advisors say, “That’s not for me because I’m a numbers guy,” I tell them what I’d tell a physician who says he doesn’t care about bedside manner: “You can be a pathologist!”
A final word for FAs?
Financial advisors are very much like the physicians who resist science. Such advisors just want to think about their work as art, when it’s really science. They want to consider themselves painters, when in fact they should be more like technicians and good physicians — people who are on the frontier of financial knowledge but who also have a good bedside manner.
It’s important for advisors to know that their job isn’t just maximizing wealth but maximizing well-being at least as much, if not primarily.