Volatile markets can trigger investors to make some troublesome moves, such as panic selling or euphoric buying – and it’s the financial advisor’s role to try to manage those behaviours before they wreak havoc on a client’s portfolio.
Most advisors aren’t trained psychologists, but may need to think like one by recognizing the cognitive biases that can potentially fuel destructive investor behaviour. It’s part of the growing field of behavioural economics, which is the study of how economic decisions are made based on psychological, emotional, cultural and other social factors.
“Volatile markets are a time for advisors to step into a therapist role,” says Tea Nicola, co-founder and chief executive officer of Vancouver-based robo-advisor firm WealthBar Financial Services Inc. “You need to listen to what they’re saying, how they’re feeling and ask questions to guide clients to make decisions themselves. ... It’s a coaching exercise more than a sales pitch.”
Advisors should start by recognizing the behaviours as human nature, says Lisa Kramer, professor of finance with both the Rotman School of Management and the department of management at the University of Toronto.
“Behavioural tendencies have gotten a bad rap,” Ms. Kramer says. “We need to accept that they’re perfectly natural. The question is what do we do about them? That’s where conversations between advisors and clients can be really helpful.”
Here are some common biases investors have — and how advisors can help clients avoid the potential pitfalls.
Running with the herd
Herd mentality, or making decisions based on the actions of others, is a common bias in investing and life in general. An example is investors who rush into hot stocks or sectors, alongside others, without considering how potential losses could impact their portfolios in the short and long term. Consider investors who piled money into bitcoin months before it reached a record price of US$19,783 in December 2017. The cryptocurrency now trades at around US$5,000.
There’s no harm in throwing money at risky plays, as long as investors understand the money could be lost, Ms. Kramer says. “If you can say goodbye to that money, sure, have some fun with it.”
Otherwise, Ms. Kramer recommends advisors remind clients about the history of hot sectors or stocks in which investors experienced major losses. “Diversification is the immunization against this type of behaviour,” she says.
Herd mentality also took place in the last quarter of 2018, when many investors sold off their equities when the markets dropped.
Although legendary investor Warren Buffett advises investors to “be fearful when others are greedy and greedy when others are fearful,” Ms. Nicola says advisors are more likely to recommend clients do nothing when markets fall – depending on their risk tolerance.
“It takes a lot of fortitude,” to buy when markets drop, Ms. Nicola says. “It means doubling down and investing more aggressively, and that’s hard.”
Choosing stories over analysis
Investors can sometimes make knee-jerk decisions in their portfolios based on investing stories they hear from family, friends and colleagues. An example is anecdotes about investors who went fully into cash before the 2008-09 financial crisis and avoided millions of dollars in market losses – in the short term, at least.
Some investors are using those stories as an excuse to increase the cash in their portfolios today amid worries about another recession, even if it means derailing their long-term financial plans.
“People hang on to these positive stories and think they can emulate this behaviour [in which] that outcome is as predictable as winning the lottery,” says Ms. Nicola. “It’s just luck. It has nothing to do with math or your ability to time the market.”
Her advice to advisors? “You need to tell equally compelling stories for the other side of the argument.” For example, the investors who went into cash before the global financial crisis may have missed out on a chunk of the bull market that took place during the last decade.
Prospect theory is an unconscious bias that makes humans perceive loss harder than they would celebrate an equal gain, says Ms. Nicola. As an example, investors with this trait would find losing $1,000 on a stock more painful than the elation received if the stock had gained $1,000.
“From an investor-behaviour perspective, when an investor loses a few percentage points they are much more likely to make a change and do something that would be detrimental to their long-term success because of that perceived pain,” says Ms. Nicola. “When they gain the same amount of percentage point, they are more likely to accept it as normal.”
Prospect theory is mitigated by “talking your clients off the ledge” and stopping them from going into cash, says Ms. Nicola.
Recency bias is a focus on recent events instead of historical ones when making investment decisions. This behaviour is a potential trap that millennials or other newer investors may fall into. Ms. Nicola notes these investors have not yet experienced a downturn and may find themselves questioning their risk profile due to the bad final quarter of 2018. Recency bias is mitigated by reviewing the risk profile, she says.
“Advisors have to reaffirm the risk profile, which may have been higher than that person can actually handle in the long run,” Ms. Nicola says. “It is a job of an advisor to decide whether the client should stay the course or go down in risk.”
Demonstrate your value
Advisors can demonstrate their value to clients by helping them recognize these biases. Still, you should be approaching the conversation with caution.
“The last thing you want to do is start preaching to your clients,” says Ms. Nicola. “They’ll shut down and make bad decisions. You need to validate their feelings and then gently and carefully coach them into self-identifying that they might fit into one of these biases. … When they make the right decision as a result, they will have buy-in and stick with it.”
Advisors also need to be conscious of their own potential biases that can creep into their investing decisions. An example is confusing the familiar with the safe, such as investing in a stock or a fund because they know it well and have held it for years – even after its risk profile has changed.
Thus, Ms. Nicola recommends that advisors never stop learning about themselves and investments through research, education and networking. “You have to regularly challenge yourself. It’s all about making sure you’re keeping an open mind.”