Finance, Human Behavior and Great Expectations

From frugality and generosity to fear and greed, human emotions drive decision making

by Michael Conway

Elements of human behavior have influenced some of our greatest achievements, including scientific breakthroughs, the liberation of the oppressed, and the development of stable markets.

Other elements have resulted in the spread of disease, the ascension of tyrannies, and the collapse of modern economies. While we often tout our triumphs and downplay our shortfalls, we struggle to suppress the ingrained characteristics that drive poor decisions and their consequences.

Heart disease, for example, is the number one killer of Americans, responsible for 1 in every 4 deaths per year. Alcohol abuse, smoking, and poor diet represent the most significant factors that lead to heart disease. Any sane, logical person understands that choosing to eat poorly, smoke, or drink to excess (or in combination) greatly elevates the odds of early death. Yet every day millions of Americans make these decisions at their own expense.

In the world of finance, the spectrum of behavior is as vast as in any other fragment of society. From frugality and generosity to fear and greed, human emotions drive decision making and, subsequently, our economy. While many investors credit short-term success to their “unique” short-term strategies, many also tend to repeat mistakes despite past failures. Just as a man who’s had a heart attack might choose to continue smoking, an investor whose equity-aligned portfolio dropped 50% in 2008 might want to take on additional equity risk in the current bull market. With selective memory and a hunger for yield, the fickle investor forces the ebbs and flows of the market through ill-timed trading, often capturing substantial losses along the way.

Managing The Big Variable: Human Behavior

In the financial planning industry, many advisors advertise their value proposition—or their fundamental and distinguishable worth above all others—as their ability to generate returns and protect assets for retirement.
Advisors tend to feel that their “unique” strategies (portfolio modeling, allocation, hedging, etc.) will outperform the strategies of the advisor across the street. Advisors might even think that they can better forecast economic shifts, time the market, and select products. But advisors and investors tend to forget or discount the importance of constantly managing the human behaviors that so often disrupt the success of the plan.

When advisors don’t establish the value of behavioral management with the client, fear and greed can overwhelm logic. Various behavioral tendencies examined in empirical research, including the disposition effect, anchoring, gambler’s fallacy, and confirmation bias, spur investors to depart from rationality and disregard an advisor’s well-designed portfolio.
A noise trader, for example, will follow trends and overreact to company news without truly analyzing fundamental data, resulting in poorly-timed investment changes that disrupt a portfolio’s long-term growth potential. Such noise is powerful enough to move markets, rapidly inflating or deflating share prices.

In the current market, herd behavior has manifested into higher stock prices, tempting investors to shift into equities, to detach from their long-term plans, and to discount their original (and more realistic) risk profile. In such a market, herd investors can’t bear to miss out on the upswing, yet could never handle the subsequent correction.
Even the best forecasting, market timing, and product selection can’t compensate for an investor’s fear- and greed-based actions. In reality, an advisor’s ability to serve as a behavior coach and artfully deter clients from poor decisions represents the most significant differentiator among advisors.

Indeed, Vanguard has quantified that value, dubbed the “advisor’s alpha.” In the study, titled, “Putting a value on your value: Quantifying Vanguard Advisor’s Alpha,” Vanguard shows that without an advisor in place, investors miss out on 3% in returns per year. Behavioral coaching, or hands-on guidance in all aspects of a client’s financial and personal life, constituted the largest piece of that increase (see below).

Job Function vs. Value Proposition

In prospecting clients, many advisors are promoting the wrong aspects of their work, thus missing an opportunity to best communicate their true importance.
While particular investment strategies might help define the success of a financial plan, advisors shouldn’t fully attach their value proposition to that aspect of their job function. That’s like an editor suggesting that eliminating typos adds value to a reader.

In reality, only the inadvertent inclusion of typos minimizes value to the reader, just as a poorly designed portfolio cuts an advisor off from the herd. In other words, creating portfolios and eliminating typos are the basic functions—not the added value—of the job roles. Operating as a true behavioral coach best distinguishes advisors from an otherwise level playing field.

Advisors might argue that they must pander to investors’ search for yield to earn business. Advisors must often address questions like, “How can you earn me more than my current advisor?”

In response, advisors should reshape perceptions of what it means to achieve financial security, set realistic expectations, and stress the importance of committed coaching. That genuine desire to provide constant instruction and compassionate support, combined with high-level responsiveness, can garner immense (and well-deserved) trust. Long-term stewardship and persistent management not only help capture returns, but also breed long-term, successful client/advisor relationships.
As markets make dramatic short-term swings and clients come forth with trade requests, planners need to practice what they preach and effectively mitigate harmful behavior. In other words, advisors can’t cave at a client’s desire to disrupt a plan based on an irrational inclination. Instead, advisors should reintroduce logic with reminders of the long-term strategy and better establish a cooperative approach. Advisors that understand their own value are best equipped to ensure clients “stay the course,” avoid the common pitfalls, and achieve financial security for their clients. ♦

Sources:
Kinniry, Francis M., CFA, Colleen M. Jaconetti, CPA, CFP, Michael A. DiJoseph, CFA, and Yan Zilbering. “Putting a Value on Your Value: Quantifying Vanguard Advisor’s Alpha.” (n.d.): n. pag. Mar. 2014. Web. May 2015.