Helping to Save Investors from Themselves

As America’s financial crisis attempts to resolve itself, one can only wonder what comes next. So many unnerving events have happened during such a short time span. But don’t let any of this keep you from a good night’s sleep. Even when we thought we knew what was coming, most of us didn’t. Most of the financial media along with Wall Street’s forecasters have proven themselves to be consistently wrong too. Still, one thing we can say with 100 percent certainty as 2008 comes to its conclusion is that the herd mentality rules.

In case you’ve forgotten, here’s a brief recap of what the herd has been doing over the past 10 years:

In 1999 the herd was buying Internet stocks. Then, after getting massacred, they lost interest in stocks and around 2003 they started buying real estate. Eventually that got old. And today, now that they’ve lost their homes and almost everything else they own, guess what the herd is doing? They’re selling stocks.

This year’s lousy performance of key stock benchmarks is merely a reflection of the panic selling that has engulfed the masses. TrimTabs Investment Research estimates that investors yanked around $43 billion from their equity mutual funds.

Even though history has been screaming at them, the herd still hasn’t learned from it because they’ve been too busy to notice that it’s in the process of repeating itself all over again. Did they forgot about what happened after the Great Depression, the crisis during the 1970s and the crash of 1987? As a result of their own ignorance, the herd’s cycle of losing continues.

What’s their problem? Maybe the better question is what isn’t their problem.

Risk? What’s That? During a bull market many investors shove aside the financial risks of investing. The tendency is to underestimate risk. But things change quickly once they see their investment accounts fall in value. “All too many investors were led to the mistaken conclusion that big losses wouldn’t bother them,” says Jason Zweig, author of Your Money and Your Brain (Simon & Schuster) “These people paid a terrible price for their poor self-knowledge.”

If there’s anything that can be said which is good about a bear market, it’s that it teaches people they probably took more risk than they previously realized.

Helping your clients to recalibrate their portfolio’s risk with their own level of risk tolerance is the obvious solution. If their personalities can’t handle the volatility of stocks, dialing down exposure can put them back on track. Likewise if they overdosed on individual stocks, help them to diversify into broader stock index funds like Vanguard’s Total Market ETF (VTI), the iShares Russell 3000 (IWV) or the SPDR DJ Wilshire 5000 (TMW). They can keep their exposure to stocks but reduce the risk and impact of single-stock blow-ups.

Bad Behavior Academia has invented a relatively new field of research going by the names “behavioral finance” and “neuroeconomics.” The point of behavioral finance is to attempt to explain the financial decisions investors make. It tells us why investors have the tendency to act a certain way when they are given a set of choices or specific circumstances.

Consider some of the behavioral problems that afflict investors: beginner’s luck; confirmation bias; illusion of control; illusion of knowledge; false consensus; failure to save; fear of loss; gambling; greed; herding; magical thinking; money illusion; overconfidence; overreacting; procrastination; regret; self-deception; selective thinking; status quo bias; winner’s curse.

Before people can make prudent or informed investment decisions, they first need to eliminate the behavioral problems that are preventing them from succeeding. That’s where you come in. Working with a financial advisor (you) can help people to avoid self-destructing because of fear, regret or some other emotional problem. Help your clients to get out of the way of themselves.

Not SavingWe live in a society with a spend-now, pay-later mentality. For that reason, America’s consumerism is killing people financially. Want proof?

The personal savings rate among all U.S. consumers during 2006 was negative 1 percent, according to the Commerce Department. This was the worst showing since the two-year period of 1932-33 during the Great Depression. Interestingly, that negative 1 percent savings rate was recorded when the stock market and housing market were performing decently well. Think about it. If the typical American couldn’t save money when times were good, what can be expected of them now?

After decades of hard work, one would expect older workers to be in good shape financially, right? Wrong. In fact, older Americans haven’t accumulated enough money to generate sufficient retirement income. According to a 2007 Retirement Confidence Survey conducted by the Employee Benefit Research Institute (EBRI), three-fourths (74 percent) of workers age 55 and older report that their savings are less than $249,999.

No matter what the stock market or U.S. economy does, people that save and invest always do better than those who don’t. Not only do the numbers prove this fact true, but so does history. Please drill this message into the brains of all your clients, especially those who are tempted to cash in their retirement plans or to put 100 percent of their long-term savings into money market or cash equivalents.

Investing the Wrong WayMany people have the erroneous belief that they know how to invest. A closer look, however, shows that they resemble the Three Stooges acting out one of their crazy stunts.

Here are a few common mistakes that millions of people make every single day:

o 401(k) participants invest too conservatively. Many workers miss the growth potential of stocks by overweighting bonds and money market funds within their retirement plans. While bonds may provide them with a sense of short-term security, that’s where the benefits end.

o Older workers are taking too much risk with their money by not being diversified. A recent EBRI survey showed 25 percent of people above age 60 held more than half their retirement plan in company stock.

o Investors are impatient. From 1985 to 2005, the average redemption rate for stock mutual funds was 2.78 years, according to the Investment Company Institute. Does that sound like enough time to let your investments reach their full potential?

o Missed opportunities. Investors have forfeited more than 75 percent of their potential gains because of performance chasing and other destructive behavior, according to research by Dalbar.