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The Right Mind-set

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Did you ever wish you had the power to truly understand the minds of your clients? To see the world through their eyes and know their concerns and anxieties? Now, thanks to research in behavioral finance, you can.

For many years, academics have studied how people make decisions, particularly financial ones. They found people are not always the rational beings hypothesized by efficient-market theorists. Instead, their decisions are sometimes affected by preferences, biases, and perspectives that are “nonrational.” Such nonrational behaviors can undermine an investor’s long-term success. At a minimum, they arouse feelings of pain and anxiety that can make investing an unpleasant experience. They can also cause investors to take actions inconsistent with achieving long-term financial goals.

When you understand these nonrational tendencies and learn how to deal with them more effectively, you can add significant value to your client relationships. A good time to help clients deal with their nonrational tendencies is during periodic client meetings, when clients are focused on investment issues and may be more receptive to your suggestions. You can interact with them face to face, gauge their reactions, and deal directly with any questions they might have. Here are some ideas to help your clients overcome their nonrational investment behavior:

When to Meet?

The first issue to address is how often to have client meetings. Many financial advisors meet with clients quarterly and review in detail the performance of their portfolios. This practice grew out of the quarterly performance reviews investment consultants traditionally conduct with institutional clients. It is questionable whether this approach makes sense with individual investors, as it sends a message that short-term performance is important. If we want clients to focus on long-term goals, we should reinforce that message by conducting performance-oriented client meetings less frequently. Yet many advisors have found frequent contact with clients helps strengthen their client relationships. Therefore, you need to find a focus for meetings other than simply performance.

Focus on Personal Goals

What is a relevant benchmark for a client whose personal financial goal is to accumulate $1 million in investable assets in 10 years? To reach this goal, the annual rate of return is more relevant than a benchmark, correct? To measure the performance of a client’s portfolio against any other benchmark is inviting the client to use inappropriate “anchors” to judge investment success. Clients experience anxiety if they see their investments performing below a certain benchmark and may be tempted to take action to fix the situation. Often such action is unnecessary and could even be seriously counterproductive. As the client’s advisor, you may use a variety of tools and benchmarks to assess the performance of the portfolio or its components. However, the focus of your client meetings should be progress toward the client’s goal, not judging “winners” and “losers” based on index-related benchmarks. Turn your “performance reviews” into “progress reviews.”

The “State of Wealth”

Progress toward a client’s personal goals should be judged in terms of his or her overall state of wealth. Since a client’s long-term goals are expressed in terms of total net worth at a particular point in time, attention should be firmly fixed on that target. Yet client meetings often involve a detailed review of every investment in a client’s portfolio. As an investment professional, you should spend a good deal of time focusing on the components of the client’s portfolio without involving the client. At any given time, some investments in the portfolio will not be performing well, particularly as asset classes, styles, sectors, and industries go in and out of favor. This is why you construct diversified portfolios.

When you walk clients through a review of each investment, you invite them to do two things you do not want them to do. The first is to experience the symptoms of loss aversion for every investment not beating the market or performing up to the anchor your client may use to judge investment success. The second is more subtle. Clients take their cue from you. If you consistently walk them through a review of every investment in their portfolios, you are saying this is important. If, on the other hand, you teach them to focus on the big picture–growth of their overall net worth–most will follow your lead.

How Long Is Your Time Frame?

Remember your clients are prone to use very short time horizons in assessing their portfolios. Help them overcome this tendency by constantly refocusing their attention on their long-term goals. Time is an important dimension to discuss in order to alleviate the symptoms of loss aversion. Moderate ups and downs in the short term are of little relevance if a client’s time horizon is 10 to 15 years. Clients do not usually think in those terms unless you help them. If your meetings focus on short-term performance or recent market trends, you are telling the client these are important issues. Is this the message you want to send? Use the meetings to listen, build trust, and make sure the client is still within his or her comfort zone. Focus on things you want the client to focus on.

Use Meetings to Educate

Periodic meetings are a great opportunity to educate clients and reinforce the view you want them to have. Make sure your clients look at investing as a probabilistic venture. Help them understand that not every investment will pay off. The key is to make solid progress toward their goals.

Help your clients distinguish between bad decisions and bad outcomes. The fact that not every investment works out as hoped does not mean the decision to invest was bad. Investing is inherently risky. The key is to be right enough of the time so your clients reach their goals. Clients who grasp this idea will be more satisfied investors.

What’s Your Message?

Pay attention to the content of the performance reports you provide. Most reports are derived from forms used by institutional investors. But there are important differences between the information needs of individual and institutional investors. Because of these differences you may be sending the wrong messages to clients.

Consider whether your performance reports support or undermine the idea that clients should judge their investment success based on progress toward their long-term financial goals. Many performance reports don’t; instead, they are full of comparisons to indexes, universes, and other benchmarks. If a report does refer to the client’s goals, chances are those goals are not prominently featured.

Remember not to put unnecessary emphasis on each component of the client’s portfolio. Avoid analyzing the performance of each individual investment. Use consolidated performance reports and account aggregation services to focus attention on the client’s overall financial picture. Avoid providing separate performance reports for each account. And evaluate the message your report sends about the importance of using a long time horizon for assessing investment success. Does your report put undue emphasis on short-term performance? If so, refocus attention on the long term. Show “since inception” numbers first and de-emphasize short-term performance.

During difficult times in the market most portfolios will suffer to some degree. This does not mean your client’s investment strategy is in trouble. However, any time clients see a decline in the value of their portfolio they may experience symptoms of loss aversion.

To address this issue, there are two ways to illustrate portfolio performance through graphic presentations in your reports. One approach is to show your clients the range of likely returns over a given period of time. This can be done using a “funnel” chart or a Monte Carlo simulation. These show clients they may encounter a fairly wide range of results as they move forward with their investment strategy, particularly over short time periods. They can also see, as time moves forward, that the expected range of returns narrows and the probabilities of reaching their objectives improve.

For example, in the funnel chart below, the client can see a long-term target return expressed as a straight line running horizontally through the middle of the chart. Over and under the target return line are two curved lines that represent the expected high and low returns for the client’s portfolio, within a 90% range of certainty. Once clients understand their investments are expected to deviate from average annual return targets, they won’t be as concerned when a return temporarily drops below them, particularly when it is still within the range they expected from the beginning.

Another technique to send your message is to use a behavioral tendency known as the “house money effect.” Imagine you walk into a casino with $100. Before you know it, your original $100 has grown to $300. You tuck the original $100 in your wallet and play with your $200 in winnings–your house money. Now you become more aggressive and less concerned with losing.

Use the house money effect in performance reports. Make sure every report contains a graphic depiction that separates the client’s initial investment from his or her gains. In the chart to the right, the original investment and subsequent contributions are shown in yellow. Gains are in red. Together they make up the total value of the client’s portfolio. Over time, the client’s portfolio generates gains and the red section of the graph will grow. This way, when the markets encounter difficult periods and the portfolio value dips, the client will really grasp he or she has lost a little house money, but the original investment is still intact. This helps reduce the anxiety associated with declines in portfolio value.

Organize Client Meetings

Here is a road map you might consider using the next time you meet with clients. Start by focusing on long-term goals, both in terms of desired outcomes (say, enough money to retire in 15 years at age 65) and the amount of money necessary to secure the desired outcome (for example, $1 million in investable assets in 15 years). Use the client’s statement of investment policy as a guide. If the client doesn’t have one, develop one that incorporates the client’s goals, annual return objectives, portfolio risk targets, asset allocation strategy, limitations on investments that can be included in the portfolio, and a methodology for measuring progress, such as frequency of valuation and yardsticks to be used.

At each meeting, make sure the goals and objectives that were used to create the client’s investment strategy are still appropriate. This discussion will yield information about the client’s life that may have a bearing on his or her investment needs. Then review clients’ progress toward their long-term goals in terms of their overall net worth. Do this in the framework of the range of possibilities you described for the clients when devising their investment strategy. If clients are unhappy with their progress, try to be empathetic and confident and to reassure them about the future, but avoid promising specific results.

Point out aspects of the portfolio that are doing particularly well or poorly, in terms of helping clients understand what contributes to or hinders progress toward their long-term goals. Let the clients know you are monitoring any poorly performing investments, but treat them as an expected part of investing so the clients’ confidence in their overall strategy is not undermined. Discuss any recommendations you have to modify the portfolio, and explain them in terms of how they will affect the clients’ progress toward long-term goals.

Ask clients about concerns they have about their investments. This should go beyond the assets you advise in their portfolios and should include their complete financial situation. Also ask about clients’ experience as investors. Are they comfortable with the amount of unpredictability in their portfolios? Ask how they obtain investment information and how often they check the value of their investments. You may uncover anxieties you should be aware of.

The experience of being an investor can be difficult for clients, particularly during volatile markets. By using your knowledge of behavioral tendencies, you can relieve anxiety, help clients overcome obstacles to investment success, and bolster client relationships by helping them stick with their strategy over the long term.