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Investor Behavior and the Financial Planning Process

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The role of the “financial advisor” has quickly evolved over the last 15 years.  While the tradition of bringing clarity to someone’s overall financial life and planning accordingly has remained steadfast, the role of the “counselor” has become more prominent in the wake of two major market downturns (2001-2002 & 2008-2009). While most of us have learned that our emotions can quickly trump our logic during very uncertain times, having those emotions dictate our financial plan usually leads to very poor outcomes. This has in fact become the biggest value that an advisor can bring to the table for their clients since not managing emotions during turbulent times is often the largest expense that investors will pay.

This is in no way to deflate the importance of Step 1, which is to bring clarity and a plan of attack for investor’s and their finances. Finke & Huston (2014) state, “Financial literacy in the United States is surprisingly low, and certainly too low to expect that consumers can make effective financial decisions with many of the most complex product markets.” Utilizing the knowledge of an independent financial professional is extremely worthwhile for anyone who doesn’t have the time to self-educate on the numerous topics of investing, estate planning, insurance, taxes, charitable giving, etc. But no plan is a good plan if you decide to abandon it when things get tough. Hence, a good advisor now has to take the next step and incorporate what we have learned about how we, as a human race, make decisions under uncertainty so that we can protect ourselves from ourselves.

A recent white paper in the Journal of Financial Planning did a very nice job summarizing the research that has been performed over the last 4 decades. Mainly based off of the work of Amos Tversky and Daniel Kahneman, who won the Nobel Memorial Prize in Economics in 2002, the research has demonstrated that individuals are not always rational nor utility optimizing, which have been assumptions under traditional finance theories, when making investment decisions. A series of tests and games that Tversky and Kahneman performed on their subjects revealed the many “biases” that individuals have when making decisions under uncertainty. Daniel Kahneman most famously documented the work in the book Thinking Fast and Slow. We are going to quickly introduce, summarize, and discuss the potential downfalls of these biases in the financial planning process. This can be helpful for other investment professionals to take into account when helping their own clients so they can be aware and possibly acknowledge these biases in their own decision making process. 

Heuristics – the more fancy term for “rules of thumb.” When faced with an overwhelming amount of information with limited time to comprehend it, we often rely on simple rules to make complex decisions. In our industry, the most common is to base the amount of stock exposure in your overall portfolio on the equation 100-Age (100 minus Age). Unfortunately, this simple equation does not take into account things like risk tolerance, which is very different for many types of people. Matching risk tolerance with proper risk exposure is probably the single most important part of Step 1 that we mentioned earlier. There are many tools available for financial professionals and investors alike to help bring a more quantitative approach to answering this question. We provide our Risk Capacity Survey and Retirement Analyzer at no cost on our website.

Disposition Effect – this is when investors disregard their long-term plan in hopes of short-term profit. For example, we have a set of rules that we follow to rebalance a client's portfolio as well as harvest capital losses within their portfolio. Some investors may want to sell their appreciated assets early to lock-in a profit or decide not to harvest losses in hope that the particular segment of their portfolio will rebound. In essence, investors are trying to predict what the market is going to do versus sticking with their long-term plan. We rebalance portfolios based on a cost-benefit analysis that incorporates transaction costs, portfolio risk, and cash flows. Likewise, we harvest losses based on the amount of capital losses, transaction costs, and the opportunity cost of being out of a particular segment of the market versus a viable alternative. Sticking with a rules-based plan is more than likely to keep investors on track and remove the inclination to try to predict where the market is going to go. 

Mental Accounting – this is a very popular bias in which clients segment their portfolio into parts instead of looking at it in whole. For instance, many investors might see losses within the Emerging Markets segment of their portfolio and want to sell it because it has incurred a short-term loss without understanding the long-term role that Emerging Markets has within their portfolio. Likewise, many investors like to sort their financial goals into “buckets” where they separate their portfolio into needs, wants, and desires without taking into account the correlation each bucket has with one another. It is important that an advisor understands their client’s entire financial situation and educates their clients on looking at the entire picture and not just in segments.

Overconfidence – this bias is pretty much straight forward and is probably the most common amongst investors and financial professionals alike. In short, this is when investors believe that they can handle all of the intricacies of their financial lives. Whether it is picking the right stocks, timing the market, knowing how much insurance they need, etc. Unfortunately, more times than not, overconfidence leads to investors falling on extreme sides of the investment spectrum. On one side, they are spending all of their free time looking at technical indicators or analyst reports and day-trade or they fall on the complete opposite side of the spectrum where they do absolutely nothing because they believe they have everything under control. For financial professionals, this is probably one of the most difficult to overcome, but persistence goes a long way in helping these clients.

Self-Control and Framing – investors, especially those of younger generations, often have a very tough time setting aside money for retirement and would rather spend their earnings now. As a lot of baby boomers are slowly finding out, this is a recipe for disaster. Now approaching their retirement years, many investors are finding themselves way underfunded and having to make drastic lifestyle changes. As an advisor, it is important to implement strategies that will help individuals save for retirement automatically as well as frame the decision in a way that is productive. For example, instead of telling an individual that by saving 10% of their income between now and retirement will yield an overall portfolio balance of $800,000, it is probably more productive to frame it in a way that is more palpable to that individual. For example, saving 10% of your income between now and retirement will yield a monthly paycheck of approximately $1,500 before taxes. Most people understand this concept better since it corresponds to how they currently see their income and can make adjustments to their behavior from there.

Familiarity Bias – often times, people will only invest in things that they are familiar with. For United States citizens, this is going to be the biggest companies that are domiciled within the United States like Wal-Mart, Coca Cola, and Exxon Mobil. This often leads to portfolios that are heavily concentrated and poorly diversified. The United States by itself only makes up about half of the entire global market capitalization. There are more opportunities to diversify a portfolio outside of the United States as well as take advantage of the dimensions of expected return within smaller companies and those companies that have low prices relative to their book value (i.e. value companies), which have been shown to have a higher expected return than the big “blue chip” companies that we mentioned earlier. At IFA, we have data, charts, articles, and videos to help explain the benefits of diversifying across many different asset classes. Education is the key to understanding.

In conclusion, the role of an advisor can no longer be based solely on coming up with a plan. It now extends into helping clients maintain that plan when times get tough, taking into account what we have learned about how we think when faced with uncertainty. Benjamin Graham, the father of value investing and mentor to Warren Buffett famously said, “Individuals who cannot master their emotions are ill-suited to profit from the investment process.” We cannot expect our clients to abandon their emotions, but we can help our clients manage them.

If you are interested in speaking with an IFA Wealth Advisor, click here, or call us at 888-643-3133.