Teaching Moments: Help Clients Shake the Emotional Hangovers

Sue BerginSue Bergin, President, S Bergin Communications

While the I-make-a-decision-and-forget-about-it approach might have worked for Harry S. Truman, it does not describe the vast majority of today’s investors.

According to our recent Brinker Barometer advisor survey[1], only 22% of advisors clients embrace Truman’s philosophy. The vast majority of clients suffer from emotional hangovers after periods of poor performance. They let the poor investment performance impact future decisions. Sometimes, it is for the better. In fact, 31% of clients made wiser decisions after learning from poor investment performance. Nearly half of the respondents, however, claimed that emotions cloud the investment decision following poor performance.

Bergin_LiveWithDecisions_7.30.14Another recent study, led by a London Business School, sheds light on how advisors can increase satisfaction by helping clients make peace with their decisions. According to the research, acts of closure can help prevent clients from ruminating over missed opportunities. To illustrate the point, researchers simply asked participants to choose a chocolate from a large selection. After the choice had been made, researchers put a transparent lid over the display for some participants but left the display open for others. Participants with the covered tray were more satisfied with their choices (6.30 vs. 4.78 on a 7 point scale) than people who did not have the selection covered after selecting their treat.

While the study was done with chocolate and not portfolio allocations, behavioral finance expert Dr. Daniel Crosby says that it can still provide useful insights on helping clients avoid what Vegas calls, “throwing good money after bad,” and psychology pundits refer to as the “sunk-cost fallacy.”

“Many clients are so averse to loss that they will follow a bad financial decision that resulted in a loss with one or more risky decisions aimed at recouping the money. If you detect that a client is letting emotional residue taint future decisions you should counsel them to consider the poor performance as a lesson learned. This will allow the client to grow from the experience rather than doubling the damage in a fit of excessive emotionality,” Crosby explains.

[1] Brinker Barometer survey, 1Q14. 275 respondents

The views expressed are those of Brinker Capital and are for informational purposes only.

Everyone’s Unique

Jeff Raupp Jeff Raupp, CFA, Senior Investment Manager

Whenever I go to the bowling alley it strikes me how unique people are. And no, it’s not because of the multi-colored shoes or even the matching team jackets complete with catchy names like “Pin Pals” or “Medina Sod” sewn on the back. It’s because of the bowling balls.

Every time I head to the lanes, I can bank on spending at least ten minutes trying to find a ball that works for me. You have the heavy balls with the tiny finger holes and the huge thumb, the balls with the finger holes on the other side of the ball away from the thumb, and the ones where it seems like someone was playing around and drilled three random holes. Half of the time I find myself weighing the embarrassment of using a purple or pink ball that feels okay versus a more masculine black or red ball that weighs a ton but can only fit my pinkie. I’m always left thinking, “Where’s the guy or gal that this ball actually fits?”

Raupp_Everyones_Unique_2.14.14But at the end of the day, I find that if I find the right ball, where my hand feels comfortable and the weight is just right, I have a much better game.

In the same way, how to best save toward your life goals is unique to each investor. Even in the scenario where two investors have the same age, same investable assets and generally the same goals, the portfolio that helps them achieve those goals may be decidedly different between them. Investor emotion can play a huge role in the success or failure of an investment plan, and keeping those emotions in check is vital. There is nothing more damaging to the potential for an investor to meet their goals than an emotional decision to deviate from their long-term strategy due to market conditions.

Fortunately, there’s often more than one way to reach a particular goal. There are strategies that focus on total return versus ones that focus on generating income. Strategies that are more market oriented versus those that look to produce a certain level of return regardless of the markets. And there are tactical strategies and strategic strategies. For any investor’s personal goal(s), several of these, or a combination of these, might provide the necessary investment returns to get you there.

Raupp_Everyones_Unique_2.14.14_1Here’s where the emotions can come into play—if you don’t feel comfortable along the way, your emotions can take over the driver’s wheel, and your investor returns can fall short of your goal. In 2008-2009, many investors panicked, fled the markets, and decided to go to cash near the market bottom; but they missed much of the huge market rebound that followed. While in many cases the investors pre-recession strategy was sound and ultimately would have worked to reach their goals, their irrational decision during a period of volatility made it a tougher road.

Unfortunately, you don’t have the benefit of rolling a few gutter balls while you’re trying to find the right portfolio. That’s why working with an expert to find an investment strategy that can get you to your goals, and that matches your personality and risk profile, is vital to success.

Good bowlers show up at the alley with their own fitted ball and rightly-sized shoes. Good investors put their assets in a strategy fitted to their goals.

Applying Behavioral Finance To Investment Process Crucial To Financial Advisors, Brinker Barometer Finds

Earlier this week, the results of our latest Brinker Barometer advisor survey were made public. Click here to read the full press release. This particular Barometer had a focus on aspects of behavioral finance and how advisors gauge progress towards meeting their clients’ financial goals.

Check out some of the most interesting survey results in the infographic below!

1Q13BrinkerBarometer_5_14_13

Behavioral Finance 101: Irrationality

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

In part one of our three part series, we touched on “heuristics”, or the experiential rules of thumb that serve as decisional markers. Part two will discuss a second pillar of behavioral finance, irrationality. But before we can talk about irrationality in any meaningful way, we must define what it means to be irrational.

One of the hallmark difficulties of psychology as a science is that it requires “operationalization” of the subjective variables it hopes to measure. That is, it must provide sometimes-ethereal constructs such as happiness or rationality with a set of parameters that allow them to be measured and interpreted. When traditional economic models were constructed, they needed to account for things such as “utility” that had to be operationalized to be accounted for within the model.

Using the logic of the time, they put forth the seemingly straightforward maxim that a rational investor, homo economicus, would act to maximize utility at all times, with utility being defined as dollars and cents. Basically, economic decision makers would consistently act in such a way that their investment returns would be improved to the extent possible.

5.22.13_Crosby_Blog2This idea of rational investors working to maximize returns had two profound positives that served it well over the many years it enjoyed preeminence: 1. It had intuitive appeal 2. It was easily measured. After all, do not most of us engage in all manner of unpleasantness (e.g., staff meetings) to make a buck? And are not dollars more easily debited and credited than say, units of happiness or some other more vague notion of utility? Resting on these two foundational strengths, the idea of rational, wealth-maximizing investors persisted for decades…until the music stopped playing.

Four hundred years ago, in one of the first speculative bubbles on record, a Dutch commodity traded for 10 times the annual salary of a skilled laborer. In some cases, this commodity fetched as much as 12 acres of prime farmland and even single family dwellings.

The commodity of which I’m speaking is a single tulip bulb.

5.22.13_Crosby_BeFiBlog_2_pic2You see, it was thought that tulips were an investment that would always appreciate in value and were immune to the ups and downs of comparable tradable goods. Fast forward three hundred years to 1925 and you would have heard statements like this from the investment gurus of the day…”there is nothing that can be foreseen to prevent an unprecedented era of prosperity.” Sure there had been disastrous crashes in the past, but this time was different.

It’s comforting to think of New Era mindsets as a relic of the past, a trick of the mind that fooled investors less savvy than ourselves. But as recently as the Great Recession of the past five years and the tech bubble of the turn of the century, New Era Thinking has been more present than ever. In the wake of these most recent crises there has been a dramatic uptick in the acceptance of the fact that investors are simply not rational. Quite the contrary, we engage in a number of irrational behaviors that can thwart our best efforts at financial security. This danger is especially real inasmuch as we remain unaware of their impact.

In 1998, eToys.com, an internet upstart, had sales of $30M, profits of -$28.6M and a total market capitalization of $8 billion. Toy veteran Toy’s R Us on the other hand, had more than 40 times the sales but only ¾ of the total stock value. The advent of the internet was greeted by Wall Street with great enthusiasm, such great enthusiasm that people lost their minds. The thought that the web would revolutionize the way we do business was correct, but the notion that financial fundamentals no longer mattered was not.

5.22.13_Crosby_BeFiBlog_2_pic3Another example of investor irrationality is the belief that our mere involvement with an investment will make it more profitable. A recent study found that people were willing to pay a mere $1.96 for a lottery ticket with 1 in 50 odds if they were assigned a ticket randomly. However, if they were able to choose their number from among the 50, they were willing to pay $8.67 for the ticket. The odds remained at 2%, but the participants agreed to pay over four times more if they could become personally involved. After all, they felt their involvement spelled positive change. It goes without saying that paying four times as much for something with no measurable increase in the probability of success can hardly be called rational.

I could go on, but the point here is not to erode your confidence or create a lengthy list of your imperfections. The point is to heighten your awareness of the potential for irrationality to damage you financially in ways that have a real impact on you and your loved ones. After all, you can’t correct for what you don’t acknowledge. If there is any good to come out of the trillions of dollars in capital that vanished during the bubbles of the last 13 years, it may be that we have been permanently and irrevocably humbled and have a greater sense of the limits of our own rationality. Hopefully we’ve learned our lesson. Hopefully, this time really is different.

Behavioral Finance 101: Heuristics

DanielCrosbyDr. Daniel Crosby, Ph.D., IncBlot Behavioral Finance

While the field of behavioral finance has been around for 40 or so years (depending on who you ask), it truly came into its own in 2002 when Daniel Kahneman received the Nobel Memorial Prize in Economics for his work around uncertainty and decision-making. Although he claims never to have taken an economics class, Kahneman’s work shed new light on the ways in which actual people behave under real-life circumstances, as opposed to the idealized assumptions of efficient market hypothesis, the theretofore ascendant paradigm for understanding investment outcomes.

While one of the nagging critiques of behavioral finance is that it has no mutually-agreed-upon philosophical framework, most psychologists divide it into three pillars: heuristics, irrational behavior and framing. Over the next few weeks, we’ll take each of those three pillars and try and understand them a little more deeply. In so doing, we’ll also tackle the “so what” of behavioral finance for the average investor. Without any further adieu I give you Part One of our survey course on behavioral finance – Heuristics.

I’m not sure what time of day you’re reading this, but whenever it is I can be sure of one thing: you’ve already made a lot of decisions today. First of all, there was whether or not to hit the snooze button. Then, what to have for breakfast? Luffa with body wash or bar soap in the shower? Grey suit or navy suit? And so on and so forth. The point is, given the myriad decisions we all face every day, it’s no wonder that we end up relying on heuristics or experiential rules of thumb, when making even important decisions. To give you a little firsthand experience with heuristics, I’d like to ask you to do the following:

5.9.13_Crosby_BeFiBlog_1Quick! Name all the words you can that begin with the letter “K.” Go on, I’m not listening. (Insert Jeopardy theme song here). How many were you able to come up with? Now, name all of the words you can in which K is the third letter. How many could you name this time?

If you are like most people, you found it easier to generate a list of words that begin with K; the words probably came to you more quickly and were more plentiful in number. But, did you know that there are three times as many words in which K is the third letter than there are that start with K? If that’s the case, why is it so much easier to create a list of words that start with K?

5.9.13_Crosby_BeFiBlog_1_pic3It turns out that our mind’s retrieval process is far from perfect, and a number of biases play into our ability to retrieve data with which we’ll make a decision. Psychologists call this fallibility in your memory retrieval mechanism the “availability heuristic,” which simply means that we predict the likelihood of an event based on things we can easily call to mind. Unfortunately for us, the imperfections of the availability heuristic are hard at work as we attempt to gauge the riskiness of different decisions, including how to allocate our assets.

In addition to having a memory better suited to recall things at the beginning and the end of a list, we are also better able to envision things that are scary. I know this first hand. Roughly six years ago, I moved to the North Shore of Hawaii along with my wife for a six-month internship. Although our lodging was humble, we were thrilled to be together in paradise and eager to immerse ourselves in the local culture and all the natural beauty it had to offer. That is, until I watched “Shark Week.”

5.9.13_Crosby_BeFiBlog_1_pic5For the uninitiated, “Shark Week” is the Discovery Channel’s seven-day documentary programming binge featuring all things finned and scary. A typical program begins by detailing sharks’ predatory powers, refined over eons of evolution, as they are brought to bear on the lives of some unlucky surfers. As the show nears its end, the narrator typically makes the requisite plea for appreciating these noble beasts, a message that has inevitably been over-ridden by the previous 60 minutes of fear mongering.

For one week straight, I sat transfixed by the accounts of one-legged surfers undeterred by their ill fortune (“Gotta get back on the board, dude”) and waders who had narrowly escaped with their lives. Heretofore an excellent swimmer and ocean lover, I resolved at the end of that week that I would not set foot in Hawaiian waters. And indeed I did not. So traumatized was I by the availability of bad news that I found myself unable to muster the courage to snorkel, dive or do any of the other activities I had so looked forward to just a week ago.

In reality, the chance of a shark attacking me was virtually nonexistent. The odds of me getting away with murder (about 1 in 2), being made a Saint (about 1 in 20 million) and having my pajamas catch fire (about 1 in 30 million), were all exponentially greater than me being bitten by a shark (about 1 in 300 million). My perception of risk was warped wildly by my choice to watch a program that played on human fear for ratings and my actions played out accordingly. This, my friends, is heuristic decision making hard at work.

Hopefully by now the application to investment decision-making is becoming apparent. For so long, we have been sold an economic model that posited that we had perfect, uniform access to information and made decisions that weighed that information objectively. In reality, our storage and retrieval processes are imperfect, with recent and emotionally charged pieces of data looming larger than the rest.

5.9.13_Crosby_BeFiBlog_1_pic4Investors and financial services professionals that understand these imperfections are better positioned to understand the limitations of their knowledge and try to intervene accordingly. At times this may mean taking a more tentative position to circumvent undue risk. Other times this may mean digging a little deeper on what may initially appear to be a foolproof trade. Whatever the case, it is only after we free ourselves from the myth of homo-economicus, that we are able truly become our best investing selves. Making decisions based on subjective logic needn’t be your undoing as an investor, but assuming that you’re a perfectly logical decision maker just might.

Impatience and Sadness: Two Costly Emotions

Sue BerginSue Bergin

If you had to name the top three emotions that cause people to make bad financial decisions, you’d probably say anger, guilt and fear.  While these are true, there are two more emotions to add to the list—sadness and impatience.

Psychological scientists from Harvard Kennedy School of Government and Columbia University recently published a report on November 13 that show a correlation between sadness, impatience, and poor financial decision-making.

The researchers asked participants questions with both short- and long-term financial implications.  Before answering, however, half of the participants had to watch a sad video.

sadness

The study found that these two emotions could be quite costly.

Participants subject to “sadness conditions” earned significantly less money than the participants who did not view the video.  They valued future rewards on average 13% to 34% less than their “neutral state” counterparts.

The researchers concluded that sadness triggered impatience – another emotion that produces poor financial results. When sad, people craved immediate gratification.  Sadness triggers impatience; impatience causes people to forgo future gains in exchange for instant gratification.

The Magic Number Is…

Sue BerginSue Bergin

There was a time when someone earning a six-figure salary was said to be doing well.  Is that the case today?

Towards the end of 2010, in a survey by WSL/Strategic Retail, we learned that 18% of American households earning between $100,000 and $150,000 said they could only afford the basics.   Another 10% in that salary range reported that sometimes they couldn’t even meet their obligations.

The conclusion of the survey identified a magic number—$150,000.  This was the level with which the vast majority of consumers (88%) said they could buy what they need while still being able to afford extra items and have some savings.

A more recent study by Pew Research Center puts the $150,000 figure at a higher standard of living than just being able to meet basic needs and afford a few extras.  According to Pew, $150,000 earns a family of four the status of “rich”.  This is geographical; Northeast and suburban respondents upped that amount to $200,000 while their rural counterparts said that a family making more than $125,000 could be considered wealthy.

Whether the income level is $125,000, $150,000 or $200,000 doesn’t really matter.  Incomes this high are out of reach for the vast majority of Americans.  In fact, according the Census Bureau’s September 2012 report, annual household income has fallen for the fourth straight year to an inflation-adjusted $50,054.

Let’s assume for a moment the majority of your clients earn more than $150,000.  Do they all feel rich?  Many probably do not, particularly if they are among 29% of Americans underwater on their real estate.[1]

In fact, that rich feeling is fairly elusive.  Many millionaires don’t even feel rich.

According to Fidelity Investments’ latest report on millionaires’ attitudes towards investing, 26%of millionaire respondents said they did not actually feel rich, and that they would need an average of $5 million of investable assets to begin to feel wealthy.

Politicians, economists, sociologists and even our brethren in the financial services industry continue to confuse comfort and net worth, and perception and reality.  The fact of the matter is that the words “wealthy” and “rich” more aptly describe an emotional state than a statement of net worth.


[1] The Week, Real estate crisis:  Americans Underwater 12.2.11