Remaining Rational in an Irrational Marketplace
Remaining rational is perhaps the most difficult issue for investors and financial professionals alike. Thanks to advances in online financial planning software, greater investment choices and multiple investment platforms it is possible for anyone to put together and execute an investment plan that reflects their needs and goals. The first challenge is to make sure the plan will actually accomplish the investor’s goals and objectives. Yet, the greater challenge is to not jump ship along the way. But that is what the majority of investors do.
We all have behavioral tendencies/characteristics that contribute to our individuality and influence certain decisions. Behavioral economists refer to these as biases. Biases are generally latent and their influence is often subconscious, but that doesn’t mean they aren’t there. Biases are often triggered by an external event or feeling such as an unexpected outcome, anxiety, fear or greed. Several biases influence investors to make emotional, hasty investment decisions contrary to their investment plan – and often to their peril.
The Advisor Value
There has been increased debate on the fees financial advisors charge and the value they provide. Advisors now have to compete with computer advice programs, called Roboadvisors, which is nothing more than a risk profiler and asset allocation machine. Investing on your own or with a Roboadvisor may be less expensive than hiring a human being, but you would be without sound advice and empathetic guidance at the very moment you need it. If the stock market did nothing but go up, we would all do it ourselves and save money in fees. But it doesn’t. And sometimes it goes down significantly. What good is saving 1.0% per year if you allow emotions to dictate your investment strategy, selling after sustaining losses and buying after prices have risen? Investors need professional advice and guidance for those tough times. Dalbar, Inc. has found that over the past 20 years, average stock investors have underperformed the index by over 4% per year. Makes that 1% advisory fee seem like a bargain.
Financial professionals need to embrace that one of their primary roles is to help investors mitigate the influences of biases and emotion. Professionals need to become aware of how and when biases exert their influence, and what they can do to help investors make more thoughtful decisions. There are tools professionals can (and should) employ that provide the correct “antidote” for their clients. Investors should seek out financial professionals that have access to these tools and can help them stay the course when times get tough.
Proactively Address the Biases
The best time to tackle latent biases and provide the “antidote” is when investors are in a rational state of mind. In the financial sense this state can be found when the market is just moving along, gyrating up and down without any significant moves either way. Right now is a perfect time. This is because people don’t have their guard up and biases are latent, meaning their influence is dormant – allowing you to have logical discussions and craft the proper plan (antidote). If you wait until biases and emotions are influencing your clients, you will have a much tougher job…with much less of a success rate. You can still have the conversation, but biases wreak havoc with how we analyze situations and feel. Waiting too long will make it harder to get investors to think deliberately and make the best financial choices for their future.
Irrationality is the Investors Fault, Right?
Wrong. Wall Street will often blame investors for being “irrational”; it is an excuse used when economic models do not accurately predict what really happens. Economic models assume investors act rationally – meaning they do not make cognitive errors and experience no emotions. Or in other words, economists want investors to act like a computer program so their economic model (a computer program) will be right.
It is completely irrational to expect investors to be rational at all times. Humans make cognitive errors every day, and we are all subject to emotions. To pretend or assume otherwise is completely false, yet that is what Wall Street does. Financial professionals are to help their clients reach their financial goals – despite any biases they may have. If investors were 100% rational all the time, they wouldn’t need professional guidance. The value of a financial professional increases immensely as they help “irrational” investors make more rational decisions in a manic-depressive marketplace.
It’s About the Plan
The best antidote for most biases is having a written investment plan. The strategy should specify how much downside can be tolerated. The downside should be defined in dollars; just stating a percentage loss is not sufficient. The downside risk can be determined by using a valid risk profiling instrument and/or asking specific questions. For example, the following two questions may be useful in defining a range of downside risk:
1) I would be uncomfortable and likely lose sleep at night if I lost $_____________
2) I would be devastated and likely change strategies if I lost $_______________
Once the range of loss is defined, a plan can be devised to account for the downside limits and desired goals. A target allocation should be specified and it may be prudent to also define a tactical strategy. The investment theory is to buy low and sell high. Yet, it is almost impossible to do emotionally. But if there is a written plan in place that specifies what actions would be taken if the market were to go down (i.e. if market drops 30%, increase stocks by 5%), you eliminate the need to decide at a point of great emotion. The decision was already made when the investor was in a rational state of mind…which is when all financial decisions should be made.
Investors could chose to go it alone and do the above, but just like working out at the gym, when there is no accountability it is very easy to deviate from the plan when it gets tough. Paying for a qualified advisor that understands the behavioral aspect of investing can be a very profitable strategy.