Many investors know what they should be doing, like saving for retirement and their children’s education, diversifying and rebalancing their portfolios, and building a retirement nest egg. The ongoing challenge for advisors is getting investors to actually do these things.
Why all the foot dragging? Because investment behavior is predominantly governed by emotion rather than reason. Investors’ heads tell them to invest for the long term and to follow a process rather than succumb to the ups and downs of a volatile market. But emotions–most commonly greed and fear–can derail the best intentions and cause even savvy investors to make foolish decisions.
Most advisors already know that emotions, not financial analysis, move the retail markets. Whether a client is knowledgeable or unknowledgeable about the markets, chances are good that emotions are driving her ultimate investment decisions.
For advisors, this means that clients need more than financial advice. They need behavioral advice. They need help setting long-range financial goals, developing an investment plan, and then sticking to it. Equally important, they need help steering clear of the seven deadly sins of investing: emotion, disorganization, myopia, impatience, greed, arrogance, and cowardice.
Historically, these sins have taken a heavy toll on investors’ financial well-being. Between 1984 and 2000, for example, the annualized return for the average stock fund was 13.1%, while the return for the average stock fund investor was only 5.3%. Similarly, from 1984 to 2002–a time period that includes the dot com downturn and the beginning of a recovery–the annualized return for the S&P 500 was 12.2%, yet the average stock fund investor realized only 2.6%. The performance differential may stem from several factors, but first and foremost among them are that investors committed one or more of the seven sins.
The best way for investors to counteract these sins is to adopt and adhere to a long-term investment plan. For advisors, you should familiarize yourself with the sins and the ways to help clients avoid them, and maybe to help yourself avoid them as well–after all, you’re only human, too.
Sin #1: Emotion
This sin drives almost every decision investors make. How can advisors counteract it? By putting those emotions into perspective and continually underscoring the importance of portfolio diversification. Just as consumers develop emotional attachments to certain brands, most investors have emotional connections to particular stocks, funds, or investment styles. Maybe the investor’s son-in-law works for a particular airline, and the investor continues to hold that stock in her portfolio out of a sense of loyalty, despite the fact she should have long since sold it.
Or take, for example, the fact that 74% of all new money invested in the first quarter of 2000 went into growth funds. Why? Because it was the height of the frenzy–growth funds had built significant momentum and investors were chasing performance. Just when investors should have been taking some of their chips off the table, they were instead going all in.
Similarly, advisors need to step in when investors start to anchor. Anchoring, or the inability to let go of a past event, can seriously undermine an investor’s future feelings about a stock, a fund family, or even an entire industry. The freefall of the technology sector in 2000 and 2001 created a level of fear and aversion to technology stocks that still influences many investors. By helping investors approach market opportunities as fresh every day, advisors can begin to shift the decision process from emotion to reason.
Sin #2: Disorganization
This close cousin to sloth is deadly. Investors have a tendency to have too many accounts and to spend too little time reviewing and analyzing their holdings. Without knowing it, they can seriously overweight certain industries or sectors, holding the same stocks in individual security accounts as are held in mutual funds they own. An advisor that reviews the client’s entire portfolio can identify these overlaps in an effort to help the investor attain true diversification and avoid inadvertent overweighting. As a result, swings in particular holdings won’t lead to disproportionate declines.
Sin #3: Myopia
This failing–the inability to see the forest for the trees–keeps many investors from seeing and acting on long-term trends. A sudden spike in oil prices, for example, may influence some investors’ willingness to invest in energy stocks or funds, regardless of the sector’s long-term outlook. It’s the advisor’s task to help clients focus on separating fear from fact, i.e., to develop a longer-term perspective and help them invest accordingly.