Psychoanalysis Has Met Investing. What Does It Mean For Advisors? Behavioral finance is the study of why investors think and do what they do about money and investing
By Greg Salsbury
Even if you are only an occasional reader of trade publications, you cant have escaped one of the hottest buzz-phrases in our industry: “Behavioral Finance.” The term refers to the colliding of psychology and financial theory to form a burgeoning new field of study.
You may be surprised to know the 2002 Nobel Prize winner in economics, Dr. Daniel Kahneman, is not an economist, but a psychologist. In a nutshell, behavioral finance, or behavioral economics, is the study of why investors think and do what they do about money and investing. The unflattering results show that investors can be irrational, emotional and, at times, dysfunctional.
Forget about simple fear and greed, or conservative and aggressive. Psychologists have given us a new vocabulary for describing investor behavior. Enter the brave new world of “myopic loss aversion,” “mental accounting,” “regret syndrome,” “cognitive dissonance” and “attachment bias.” One expert even provides a formula for understanding investors, explaining that “Losses hurt 2.25 times more than gains satisfy.”
There is no doubt the experts are on to something. They correctly question illogic such as: what compels people to drive 30 minutes to use a $1 coupon; wash their car to save $10, but never dream of washing a neighbors car for $10; why missing a train by one minute is so much more painful than missing it by half an hour; or why the same person who would never buy the most expensive orange juice at the grocery store has no trouble plopping down $5 for a venti, half-caf, breve latte.
But lets suppose, as a student of the game, youve done your homework and pored over the works of Hersh Shefrin in “Beyond Greed and Fear” or the extensive research of Dr. Shlomo Benartzi and Dr. Meir Statman. Or to get a more down-to-earth understanding, youve read the more layperson-friendly “Investment Madness,” by Dr. John Nofsinger.
If you have, then youve probably reacted as a patient who has finally been given, after years of suffering, the clinical definition of his ailment. And your reaction was likely something like this: “Yep, thats exactly what Ive got! So, what does it mean doc?” In other words, the whole behavioral finance craze probably has left you with one lingering questionSo what?
So, what do these great explanations of human and investor behavior mean for the typical investor? This question is where behavioral finance literature seems to leave us hanging. So, consider this article the 60-second “Cliff Notes” version of how you can use behavioral finance to help your clients avoid some of the most common financial missteps.
(1) Dont try this alone.
Understanding investment products is a complicated science. Applying these financial products to the investing process becomes art, particularly when investor behavior, emotions and biases come into play. Research shows that left to their own devices, investors make a multitude of mistakes.
They dont properly allocate assets. They borrow against 401(k)s. They overload their portfolios in a given sector or company, often with their own employers stock. They buy when they should sell, and sell when they should buy. They are overly influenced by the trend du jour.
The greatest lesson investors can take from behavioral finance is that they need the services of a financial professional. Just as the typical patient would be considered foolish to attempt brain surgery on himself, the typical investor is equally lost in this complicated world.
Help investors by illustrating how you can help them: establish goals; allocate assets; implement a long-term strategy; monitor progress; and, perhaps most importantly, provide an objective viewpoint to help investors overcome the fear and emotion that often drives investment decisions.
(2) What you dont see can help you.
The next time you meet with a client, ask how much he or she paid in taxes last year. You will find an amazing percentage of them have no clue. Dont be shocked if some proudly state, “I didnt pay any taxes. I got a refund!”
They believe this because the Internal Revenue Service engineered a model that is well suited for accumulating money without us ever missing itcollection in advance. The IRS collects its piece of our paychecks automatically, before we have a chance to spend it.
Collection in advance can help your clients become disciplined savers. An automatic investment plan allows clients to pay themselves first. Investments are treated as another part of their regular budget. Rather than spending extra income on impulse, an automatic investment plan forces investors to put more money away over the long run.
Additionally, you can show clients how an automatic investment plan and dollar-cost averaging, although not guaranteeing a profit or protecting against loss, can help reduce regret and volatility within a portfolio.
(3) Dont peekstay focused on the long term.
A long-term investment portfolio is like a bar of soap: the more you handle it, the smaller it gets. Dalbar, Inc.s 2004 Quantitative Analysis of Investor Behavior shows that over the 20-year period that ended Dec. 31, 2003, the S&P 500 returned 12.98% annually. Meanwhile, the average equity mutual fund investor earned a paltry 3.51% a year.
More interestingly, the average “market timer,” the investor who actively traded in and out of different funds to capitalize on short-term fluctuations, actually lost 3.29% annually over the period.
Behavioral finance teaches us that one of the best ways you can help a client is to convince him or her to keep the soap dish out of sight and away from the sink. Explain the importance of asset allocation, automatic rebalancing and, above all, a long-term perspective.
Encourage your clients to stop looking daily at account balances and market fluctuations. Advise them to turn off CNBC and, instead, agree to meet with you periodically to review their progress.
Further, when suitable for their investment goals, show them the advantages of allocating assets to long-term, tax-deferred investments, such as annuities, including variable, fixed or fixed index annuities. Because these are long-term investments with penalties for early withdrawal, clients are less likely to be tempted to move assets frequently.
(4) Maximize qualified contributions.
Would you turn down free money? Of course not. And neither should your clients. But it is amazing how many of them do.
The Profit Sharing/401(k) Council of America reports that 20% of workers fail to contribute to their employer-sponsored plans. These salary-reduction plans allow employees to deposit pre-tax dollars into a retirement account. Additionally, most plans offer employer-matching contributions.
Of course, employer contributions may be subject to certain vesting provisions. However, assuming your client stays on the job long enough, this is like adding “free” money to their nest egg.
Additionally, behavioral finance research shows that investors do not treat their 401(k)s the same way they do other investments. During the recent bear market, when investors moved large amounts of assets from equities into bonds, these same investors left their 401(k)s untouched.
As an advisor, you can best help clients meet their long-term financial goals by recommending they first contribute the maximum amount allowable to their employer-sponsored retirement plans.
(5) Regularly increase your savings rate.
Many people believe they have completely protected themselves by locking up their money in a fixed rate investment, perhaps one that is guaranteed by the government. While the guarantee and rate may be accurate, the safety may not be. If your client needs $50,000 today, they would need in excess of $91,000 20 years from now, assuming a 3% rate of inflation.
To help combat this increased cost of living, tell your clients to increase their savings rate. Many among them will say they will start saving more “next year.” Believe it or not, this is great news. Ask them to commit to it in writing.
Professor Richard Thaler of the University of Chicago and Professor Shlomo Benartzi of UCLA created a savings program called Save More Tomorrow (SMarT). Under this program, workers agree to boost their savings contributions automatically with each annual raise.
Studies have shown the average savings rates of SMarT plan participants jump tremendously. Bring the same concept to your practice by asking your clients to commit to increasing their savings rate annually.
In the end, the value of behavioral finance for advisors isnt about understanding complex psychological theory. The value is in understanding your clients better and in helping them take a more common sense approach to investing.
With 77 million baby boomers approaching retirement within the next 10 to 15 years, the need for saving has never been greater and the challenge for advisors never bigger. Keeping your clients on track through tough times may take some tough love, but as an advisor you sometimes need to protect your clients from themselves.
Greg Salsbury, Ph.D., is executive vice president of Jackson National Life Distributors, Denver, Colo. You may e-mail him at email@example.com.
Reproduced from National Underwriter Edition, October 7, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.