Are there ways to prevent clients from acting on self-defeating impulses and faulty thinking? Look to the fascinating findings of behavioral finance.
Apart from higher returns, investors seek other payoffs: enhanced self-esteem, and feelings of hope and exuberance, for example. But this often leads to their making the wrong financial decisions. Similarly, they can be impeded by negative emotions such as fear and despair, and by cognitive errors, like overconfidence and hindsight.
In his new book, What Investors Really Want (McGraw-Hill), Meir Statman, Santa Clara University professor of finance and behavioral finance researcher, provides deep insight into just what drives investor decisions.
A consultant to money management companies and brokerages, such as Merrill Lynch and Russell Investments, Statman, 63, educates clients and helps design diversified portfolios.
Science is the route to smarter investing, says Statman, who’s also a visiting professor at Tilburg University in the Netherlands. He urges FAs to deter clients from “the tempting voice of wants” — often prompting bad investment choices — and steer them instead toward “shoulds” — which mostly lead to smart choices.
Research recently interviewed Statman — recipient of two IMCA Journal awards, three Graham and Dodd awards and the Moskowitz Prize for best paper on socially responsible investing — to shed further light on how advisors can use the science of behavioral finance to build client trust and add value. Here are excerpts from our illuminating conversation:
Research: How can advisors save clients from themselves?
Statman: Clients are their own worst enemies. They come to advisors to tell them when to buy and when to sell, and what to buy and what to sell. But that’s not what advisors can do — period. Advisors cannot beat the market. But they can prevent clients from doing really stupid things. If advisors have that kind of conversation with clients, both would benefit.
Do FAs, then, act in a parental role?
Yes. If investors cannot control themselves, the advisor has to be the one who provides control — with a gentle voice and a bit of humor: “You’ll have to listen to me because a lack of self-control is going to do you in, and you’ll regret acting with haste. I’m here to prevent that.” Clients will understand that the advisor isn’t being a dictator but, rather, a parent. That’s what fiduciary duty is about.
What’s the best way for advisors to deal with clients’ cognitive errors, that is, flawed thinking?
Present them with science: what we know from systematic studies and logic about investing.
What’s a good strategy with clients who overestimate their investing skill and think they know more than the advisor?
Tell them, “Here’s an advantage I have over you: I’ve already learned the lesson that I’m trying to teach you, which is that there are illusions, and they’re common. For example, we remember our gains and forget our losses. I’m trying to teach you science so that you can make informed decisions.”
We know that people who try to beat the market are more [often] beaten by it. If a client thinks they can tell where the stock market will go in the coming week, ask them to keep a log, and then check it after 30 weeks.
How should advisors handle clients who want to trade often?
Scientific studies show that people who trade more, sacrifice returns and utilitarian benefits. If you show clients that trading actually reduces returns, maybe they’ll stop!
But you write that advisors shouldn’t tell investors to use reason vs. emotion. Don’t emotions lead to cognitive errors?
Investors should be mindful of their emotions. But emotions in investing aren’t always bad. Emotions reinforce learning rather than interfere with it. But you have to figure out when they get in your way.
If a client is fearful, advisors can tell them: “Fear is a natural emotion; but in financial markets, fear and its evil twin, exuberance, are going to mislead you. We know from science that fear decreases risk tolerance and increases risk aversion.” Then the advisor can point out: “I counter this by reminding myself that [in a down market], the world isn’t coming to an end. And when the time comes for real exuberance, I remind myself that the world isn’t going to be all roses.”
What if [clients are] fearful because they think the market will plunge and want to sell their stocks?
Tell them: “How about if we do this with dollar-cost averaging and get out of the market over a period of two years? And suppose we arrange that there has to be at least 10 days between the time you make a decision to buy a stock and when we execute it so that you’ll have a chance to cool off and reconsider? If it’s such a bargain, it’s likely to be a bargain in 10 days as well.”
What about anger? You write that angry people seek risk.
It’s not for nothing that our mothers taught us to count to 10 before we open our mouths when we’re angry — people who are angry are thoughtless. Anger is one emotion that drives investors to say, “I’m going to time the market”; that is, get out when stocks are high and get back when stocks are low.
When is taking risks generally a good thing?