DENVER Its an all-too-common affliction, especially when it comes to financial planning: clients sabotage their own long-term objectives.
But advisors can help prevent destructive behavior by clients by educating them about behavioral finance, according to Jay Moreland, author of "The Emotional Investor."
Speaking at the annual Schwab Impact conference, Moreland noted that a 500-point drop in the Dow has nothing to do with long-term goals. The root of the problem, Moreland says, is that humans are intuitive animals taking mental shortcuts rather than applying analysis. A solution is to change the way clients think to allow more rational decisions.
FAULTY THEORY
Modern Portfolio Theory makes three faulty assumptions, he says, and the key to avoid self-sabotage is to correct for these bad assumptions. First, returns are distributed normally, according to the bell curve as measured by standard deviation. But reality shows this is wrong as the world becomes more volatile, compounded by developments such as the financial crises and the flash crash. Advisors can correct this faulty assumption by taking less risk in a clients portfolio.
The second faulty assumption is that forecasts are accurate. We know Wall Street forecasts fail this assumption, yet the public still loves predictions of the future. We look at outcomes and then build story lines to explain why the markets went up or down on any given day. To correct for this, we should focus on a range of possible outcomes and accept that forecasts are merely entertainment.
The final faulty assumption is that investors are rational, and not affected by emotion. Biologically, we are made to be irrational. Our brains cause us to buy high and sell low. To correct, we should spend time with clients helping them to control these destructive urges. Our brain detests uncertainty, so we incorrectly interpret noise as a sense of certainty and a need to act urgently.
Moreland suggests showing clients what their returns would have been over seven years, even if they had bought the S&P 500 the day before the October 1987 crash, or other plunges if they didnt sell.
WHAT CLIENTS TRULY CAN CONTROL
Moreland also suggests helping clients focus on what they can control, such as thinking longer term by helping them understand noise and avoid herding.
Work with clients to define the maximum threshold of pain in dollars rather than percentages. Develop an investment policy statement with allocations and rebalancing strategies. Sticking with this strategy will go against instincts but increase the odds of success.
Amid efforts to help clients achieve better outcomes, Moreland says to always remember that its irrational to expect our clients or even advisors themselves to always be rational.
Read more:
