“I know you are afraid and you should be afraid. I will invest you in products that will not stir up your fears.”
This sentiment is applied over and over again in the investment industry in one form or another.
It is the mantra of what my co-author, Jason Voss, CFA, and I call the “Cult of Emotion.” The cult is so pervasive that investment professionals are hardly aware how it affects virtually every investment decision we make. It has been institutionalized through regulation, platforms, gatekeepers, advisors, analysts, consultants and even Modern Portfolio Theory (MPT), the underlying paradigm of the investment industry.
Two Choices: Cater to or Mitigate Emotions
Investors experience powerful emotions as portfolios decline in value and then reverse course and head back up. Drawdowns are especially gut-wrenching, as hard-earned money disappears before a client’s eyes.
Investors are prone to a host of cognitive errors when in thrall to these emotions. The two most prominent are myopic loss aversion and social validation. Myopic loss aversion research demonstrates that people experience the negative feelings associated with losses almost twice as acutely as the pleasure of gains. Social validation, on the other hand, is our innate desire to follow and be a part of the herd.
As investment professionals, we can do little to turn off these emotions, but we can decide how we respond to our clients when they experience them in the growth portion of their portfolios.
There are two choices: We either cater to clients’ emotions, or we strive to mitigate the damage inflicted by investment decisions made based on those emotions. Investors left to their own devices will let their feelings drive their investment choices, and that will end up costing them hundreds of thousands — if not millions — of dollars in long-term wealth. By helping short-circuit these cognitive errors, advisors and analysts can add value for their clients.
To be clear, investors are fearful and their fears need to be addressed by their investment advisor. The truth is some investors can’t be talked out of their fears, but we need to do all we can to help clients avoid these expensive mistakes.
The Problem With Catering to Emotions
Sadly, the industry encourages us to cater to — to humor — rather than mitigate client emotions. For example, current practice is to diversify across multiple asset classes regardless of the expected return. The result is a trade-off between short-term emotional comfort and long-horizon wealth. The Cult of Emotion sanctions this practice, so we tend not to recognize the damage it inflicts on client growth portfolios.