From the January 2012 issue of Investment Advisor • Subscribe!

Behavioral Economics: Your Own Worst Enemy

Balancing management styles while properly addressing risk is a tough job—VPs can help get it done

Emotional investing, performance chasing and any other term we might use to describe investors’ penchant for harming themselves isn’t a new—or particularly insightful—concept on its face. But the study of exactly how they do it is another story.

Now that the tenets of behavioral economics are breaking through to the mainstream (finally), we thought it wise to take a look back at a compelling case made for variable products (yes, variable products) as one answer to this vexing problem. This article first appeared in our sister publication, Boomer Market Advisor, in 2005, but the message is just as important—if not more so—today.

Straight from the source

“One of the assumptions economists typically make is that individuals are fully rational,” explains Dr. Daniel Kahneman, a Nobel laureate and psychology professor at Princeton University. “If you want an easy introduction to behavioral economics, it’s economics without making the assumption that [investors] are fully rational or that they have perfect self-control.”

“The definition of behavioral economics in my mind is how people react, and the economic decisions they make, in any given financial framework,” adds Dr. John Nofsinger, associate professor of finance at Washington State University and author of “Investment Madness.” “Some would argue that all finance is behavioral finance, meaning that financial decisions are too often based on emotion.”

According to Kahneman, behavioral economics includes four interwoven parts:

1. Prospect Theory: Simply put, prospect theory is the notion that individuals sometimes behave irrationally. When confronted with a risky decision, they condense available choices to a short list of alternatives and then choose the one with the perceived highest value.

2. Loss Aversion: “I realize this business is driven by hope for gain versus fear of loss,” says Robert Brimmer, an Orleans, Mass.-based Certified Financial Planner. “People are much more motivated by the latter rather than the former.”

Brimmer’s conclusion is reinforced by Kahneman’s research, which found that individuals have a tendency to be more concerned with decreases, rather than increases in the value of their investments, as well as with protection of principal.

3. Mental Accounting: Individuals typically segment their finances into separate mental boxes, using the finances in each account for different purposes. On the surface, this seems harmless enough, but investors often take it too far. Short-term decisions about the contents of any one box can negatively affect the long-term returns of the whole portfolio.

4. Overconfidence: Just as people hate to admit when they are wrong, they hate to admit to a lack of knowledge. Investors have a tendency to display overconfidence by thinking they can go it alone when it comes to making investment decisions.

The solution

According to Nofsinger, advisors can mitigate these client traits in the following ways:

  • Develop sound investment benchmarks: As ridiculous as it may sound, keeping up with the neighbors is often the client’s idea of a sound investment benchmark. Nofsinger reminds advisors that it’s best if clients act as their own benchmark.
  • Develop long-term goals: Use specific dates, and routinely evaluate investment performance against the original plan.
  • Disregard shortcuts: Longer decision-making processes avoid short-term, detrimental biases. Advisors and clients should take their time in thoroughly evaluating all alternatives.
  • Beware familiarity bias: Individuals often believe that something with which they are familiar isn’t risky. This occurs most often with employees in defined-contribution plans. Because it’s their own place of employment, they feel it is safe.

While they must be aware of irrational client traits, advisors also must be aware of what they bring to the table.

“The producer also has to recognize that they are susceptible to the same biases and emotional reactions as their clients,” says Dr. Greg Salsbury, executive vice president of Denver-based Jackson National Life Distributors. “In order to guard against this, they have to engage peer reviews, develop industry benchmarks and, most importantly, practice what they preach to their clients.”

The variable product role

Variable products can effectively address an active or a passive investment philosophy, as well as the emotional volatility and risk tolerance of the client.

For advisors, the sub-account portion of a variable vehicle is easily transferable and allows for varying degrees of allocation and diversification. The fact that these transfers can be made without incurring a taxable event (or in some cases, a surrender charge) furthers its appeal.

For clients, variable product benefits and riders allow for a more aggressive investment style without the fear of losing their original investment. For the risk averse, minimum guarantees and principal protection benefits provide needed security while still allowing for exposure to the market.

“We know that because investors are loss averse, they are going to be concerned with the protection of capital and with limiting the size of their maximum losses,” Kahneman says. “But we also know that investors like the possibility of a large gain. Therefore, combinations that offer the possibility of a substantial upside with a substantial amount of protection against losses are the features that most investors will be looking for.”

According to Salsbury, advisors should remember that all the analysis, prudent calculations, asset allocation and portfolio diversification is destroyed if the client does not trust them or follow their advice.

“Investors need to start thinking in terms of wealth accumulation, asset allocation or something that they can understand in fairly simple terms—like how much money they will have to spend each month when they retire,” he says. “How do we get investors to think this way? This is where the professional-client relationship becomes important. However, advisors also need to recognize that they, too, are human. They must recognize their own behavioral economic traits before ever explaining them to the client.”

Overall, variable products are unique in that they allow flexibility to meet the needs of the advisor and the client, wherever they lie on the efficiency-risk spectrum, and however human they might be.

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