What Behavioral Finance Teaches on How to Discuss Risk With Clients

The lessons of behavioral finance: avoid focusing on short-term volatility when the objective is long-term growth

Today’s sophisticated investors are plugged into the idea that managing volatility is critical to the well-being of their portfolios. And while investor knowledge of portfolio construction is by and large a positive occurrence, advisors who place too much emphasis on volatility management can inadvertently spook investors into taking overly conservative positions that remove too much risk and diminish long-term return potential.

Rather than burden investors with volatility worries on a tick-by-tick basis, advisors can stimulate more rational, less fear-driven choices by touching upon volatility just annually or semi-annually. Simply put: when it comes to volatility management, focusing on short-term volatility may not be the best solution for clients whose overall objective is long-term growth.

The reason for this over-emphasis on controlling volatility is explained by behavioral finance. In the well-known research paper “Myopic Loss Aversion and the Equity Premium Puzzle” authors Shlomo Benartzi and Richard H. Thaler examine investor appetite for stocks and bonds given the historical discrepancy of their returns. While stocks have pulled in annual real returns of about 7% since 1926, according to Ibbotson research, Treasury bills have earned less than 1%. Such a large chasm in performance raises the question: why would anyone prefer holding on to short-term bonds?

According to the paper, one possible explanation centers on the concept of loss aversion--a phenomenon where individuals are more sensitive to reductions in their levels of fiscal well-being than they are to increases. In other words: an investor feels the sting of $100 loss more than he experiences the joy of a $200 gain.

Short, recurring evaluation periods likewise explain why investors may unduly cling to less-risky investments. Monitoring performance at too-frequent intervals often leads to irrational and unnecessary volatility worries. The net result of these behavioral patterns is too much time spent thinking about and feeling the effects of the downside and not enough thinking about potential gains, despite the fact that gains are what will ultimately lead investors to meet their financial goals.

Exception to the Rule

For certain investors—namely, retirees and those approaching retirement—heightened attention to portfolio risk reduction is justified. Obviously, a substantial loss of net worth at this stage of

life  would be a significant hardship for all but the wealthiest individuals. Therefore a more conservative approach for the three- to five year window leading up to retirement  makes sense. But while greater attention to volatility management is warranted for these investors, for those with longer time horizons, too much volatility management can prevent the accumulation of funds needed to retire in the first place.

The reality is, there will always be volatility concerns, and managing them is a necessary function advisors must perform on behalf of clients. But discussing volatility too often can backfire. When advisors downplay the relative importance of short-term ups and downs of their account values as compared to long-term results, investor angst over volatility should fade away. When this happens, determining appropriate risk levels becomes easier and long-term goals are more likely to be achieved.

Ignoring volatility in its entirety is not a wise game plan for advisors. In our next column, we’ll discuss when volatility should be addressed and strategies for limiting downside losses without cutting into upside potential.

Disclaimer: Past performance is not indicative of future results. The opinions expressed herein reflect our judgment as of the date of writing and are subject to change at any time without notice. They are not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Information obtained from third party resources are believed to be reliable but not guaranteed.

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