Dealing with Client Self-Sabotage

[hstarn]

At the heart of behavioral finance theory is that premise that investors just aren't rational all the time. There's cognitive and emotional biases. Dealing with all that baggage leads to investment self sabotage.

Consider for example the absolutely astounding results of an investor behavior study by Dalbar for the period 1986-2005 study. The annual returns for the S&P500 Index and Treasury Bill were 11.9% and 4.6%, respectively; the average return for the individual equity and fixed income investor over the same time frame were 3.9% and 1.8%, respectively. What? How could that be? How is it possible for the average investor “going it alone” to leave 67% of the equity return and 61% of the fixed income return (just assuming the investor only invested in T-Bills rather than higher yield corporate or long-term bonds) on the table year-in and year-out?

You probably have a good hint as to the reason if you had an opportunity to listen to Dr. Basu’s webinar, “Behavioral Finance.” (You can find access instructions to that webinar in the investment archive thread of this discussion board.) I can certainly testify that during nearly a decade of actively trading equity portfolios every piece of emotional and cognitive baggage consciously and unconsciously carried with me was exposed. The gremlins of fear and greed, loss aversion, ambiguity bias, overconfidence, etc. hit me head on. Not until I learned to manage self-sabotaging tendencies through disciplined trading mindsets did I really benefit from combined fundamental and technical analysis acumen.

What experiences can you share that might help us deal with client self-sabotage?

[hstarn]

Mark Edwards

RE: Avoiding sabotage

Like Professor Starn, I've been managing money for more than a little while. And also like Professor Starn, I've made my share of mistakes.

When I managed institutional funds, I was a 'contrarian' investor, betting on out of favor stocks. These were the stocks that fundamental analysis said one should buy. Unfortunately, they seldom paid off very quickly. And in the institutional world, a quarter is a long time when one bets against the market. That is a reason why you will see managers avoiding stocks that 'should' be bought - being too early is the same as being wrong in their eyes, regardless of the stock's underlying value.

And that is one of the reasons why the Warren Buffets do well - they can afford to take bigger bets on value and wait the for rest of the market to come to the same realization. Mutual fund managers and others measured on relative quarterly returns don't have the same luxury.

I met Dick Thaler in the late 1980's, and learned of his paper on The Overreaction Hypothesis. Others had started to write on the market anomolies by then, but Thaler and Werner DeBondt actually discussed the why's of the 'bad news' reversion hypothesis. The next revelation came from a paper that discussed John Templeton's strategy of using fundamental analysis to determine WHAT to buy or sell, but using the market to determine WHEN to make the trade based on feedback - i.e. if the trade is too easy, it's too early.

The third person that I learned from was Terry Odean, who I'd known in college and remet when he was finishing up his PhD. Terry told me about his research using Schwab data that confirmed that 1] individuals trade too often, 2] for the wrong reason, and 3] with horrible results. This is confirmed by Professor Starn's return observations. I since stopped using individual stocks and focus on no-load funds. And this is why I now avoid ETF's (they are too easy to trade on impulse - which results in selling something that you researched as a good buy for purely emotional reasons).

Yes, I'm still a contrarian, and I'm still early to buy and sell funds. But I do pay more attention to trends around me to see if it's time to tip toe into and out of funds - and will be more gradual when implementing shifts.

[hstarn]

Jill Tokaczyk

RE: Helping your client become disciplined thinkers

Some useful insights are to be found in the assigned article, "Reading Between the Lines of Investor Biases" by Michelle Bolhuis and Ned Goodman, but I did find some gaps in the recommendations for financial advisors. As such, the science and art of advising clients still is a work in progress.

Very insightful is the observation that clients can develop unrealistic expectations due to their resistance to responding to change. During the last few years, especially as the economic troubles and secular bear market have persisted, I have found clients are having an extremely difficult time adjusting their financial plans and portfolios to maintain the possibility of keeping their long-term financial well-being and goals intact.

For example, I have a long-term client who is now moving to another advisor, because, as she expressed it: She didn't like my answers any more. As she loaned her daughter a sizable amount of money (who was unable to pay her back) and as the client was unable to sell some property (due to the economic downturn), I advised her not to "lend" more money to her kids for a while and to reduce her spending on trips to let her assets have a chance to build up again. Last winter, the client wintered in Arizona (not Europe) but it wasn't as enjoyable as her other winter trips, and she wants to continue spending money on her family, and so decided my advice was not what she wanted to hear. I could see it coming, but I decided I still needed to give the client the best advice I could under the circumstances. She is smart, can do the math, but her reference point still is the original retirement plan amounts (developed more than five years ago before she retired) and projections in her head, and I can't convince her that she needs to be more careful since she has spent much more of her assets much quicker than the original plan set forth.

Another couple faces a similar situation, in which the husband (an emergency room doctor in his late 50s) wants to retire soon. However, they just pulled a sizable amount of money out of their portfolio to buy a house for one of their sons (they had wanted to buy another house for another son, but I was able to convince them it would be too much demand on their financial plan). Now they are stressed because I am advising that the husband try to work a year or two longer to allow the portfolio to build up again so it can provide the income they desire in retirement. They keep looking at their assets and are discouraged that they have declined (but their emotions overshadow the fact that they have withdrawn money; they view the account performance as inadequate). I have scheduled a meeting with them to go over their financial plan again. Somehow I have to be tender (because they bought the house for their disabled son from their heart), but I also have to convey realism somewhat firmly, and still do it without dashing the husband's hope of retiring soon.

Bolhuis and Goodman advise that clients don't always say what they actually mean, and they don't always do what they say, and so it is up to the financial advisor to "read between the lines" and help them to be "disciplined thinkers." The authors say we are to do it through commitment, discipline, integrity, energy, intelligence, and a quest for knowledge. And to be careful in outlining long-term trends. That all sounds good, but I have found that reading between the lines is no easy task. Often the only way to truly help clients is not to analyze and bring their emotional variables to their attention, but to teach them the reasonable financial direction to take, and then to lead and partner with them in that direction.

Bolhuis and Goodman recommend unemotional investment policies, such as dollar-cost averaging, as a means to avoid emotional traps. That is great advise, but just part of the picture. I have found that since reducing risk is crucial (especially during bear markets), clients also need to be educated in systematic exit strategies, not only for reducing exposure to vulnerable parts of the market, but also for taming their emotions and reducing my stress.

[hstarn]

Linda Ruffalo

RE: Client Behavior

During the recent market downturn, I was charged with taking client calls and "talking them down from the ledge." In many cases, clients had not even looked at their investment portfolio, being afraid to open the envelope with their quarterly statement. Rather, they turned on the television and heard the tales of woe, certain that their portfolio had also taken such a massive loss. Curiously, the same people who were afraid to look at their own accounts, had their TV stations tuned to Mad Money or a similar program. It was Kahnemann's "comfort of the herd movement" and "far more frightened of losses than excited about gains" that I witnessed. One such client had insisted early that their entire account be placed in cash, and sat on the sidelines, yet still remained fearful that their retirement account would be diminished. Over and over, clients were suddenly watching the daily returns instead of focusing on long term results as we had been trying to coach them in the past. Another time, a client came to us because her account value was down $100,000 at their previous advisor, and wanted us to turn their account around. Upon further discussion, however, the client had several holdings that had once belonged to her parents that she was unwilling to part with, and had resulted in her losses. Rationally, the client understood this, but somehow parting with the assets meant parting with her parents. In this case, it took a lot of gentle discussion not only about her parents and their investment philosophy, her goals, and showing her how a rebalancing of her account would be in line with both of these. She needed some losses to offset gains from other assets that year, so bringing her CPA into the discussion also helped reassure her. Presentations to help her logically understand the recommendations were prepared. She was able to let go, but only after finding another familiar ground, in her talking about her parents investment style, and discovering it was about the process and not the holdings.

The article, "Reading Between the Lines of Investor Biases" reinforced to me how important it is to talk about a client's investment experiences, not experience in terms of time. What caused them the most concern, why did they select their current portfolio, and how often do they review their results? How does the news affect their decisions? In the future, I will be much more focused on digging deeper in these discussions with clients in their initial interviews , and be mindful of these results as we manage their investment portfolios.

[hstarn]

Rene Bruer

I believe that understanding a client’s history in investing, and conducting a thorough “interview” of the client, gives the planner an idea as to what the client needs to hold on to and what they can risk. More simply stated, “don’t risk something you need for something you don’t need.” I’ve experienced that managing cognitive biases is something clients expect. This is done through sharing a different opinion from a specific economist or analyst or by discussing market history that the client is not aware of. Clients understand that there are many opinions and theories of market movements, however, they appreciate when their advisor can educate them on what’s beyond Mad Money and the latest whim from the financial media.