BACK TO THE BOUTIQUE INVESTOR BLOG Short-Circuiting Emotional Investing AMG Funds As human beings, we are prone to making decisions based on our feelings and cognitive biases rather than as the outcome of rational thought. The subject of behavioral finance, which studies the psychology behind these irrational choices, got started with the work of Daniel Kahneman and Amos Tversky in the 1970s. Amos Tversky, left, and Daniel Kahneman, right. Source: newyorker.com Their research and the work of others has shown that emotional decision making pervades the human experience, making it one of the greatest dangers to your clients’ success. As one commentator summarized: “We see patterns where none exist. We have difficulty conceptualizing long arcs of time. We selectively perceive what agrees with our preexisting expectations and ignore things that disagree with our existing beliefs. We tend to forget losers and overemphasize our winners. In short, we simply are not wired for investing.”1 Finally, the best salespeople were also ready to pounce on a potential sale quickly, especially when it was a clear win-win. After thousands of rejections, sometimes the rare “yes” in sales was almost unbelievable. Good investments can be just as rare, so it is important to jump at the chance when an opportunity presents itself. It also means maximizing each opportunity with a concentrated investment approach. Enter the well-informed advisor. As your client’s financial coach, one of your most important roles is bridging the gap between a client’s gut instincts, which are often flawed, and their best interests. Dalbar’s ongoing study shows a significant gap between the returns investors make and those of the overall market.2 While some of the gap can be explained by taxes, fees and diversification measures, much of it is due to poor decision making fueled by emotions and biases. According to Dalbar, “investment results are more dependent on investor behavior than on fund performance.”3 CapitalSpectator.com September 2017 A Maturing Economic Cycle Raises the Emotional Stakes As market risk grows, the impact of good and bad investment choices becomes more significant. As we head into year 11 of the current bull market, we can expect that cycle to end sooner or later. When that happens, there will be a sizable uptick in volatility. It’s easy for clients to feel good when markets are steady, but when times turn bad, most individual investors need the help of a capable advisor in order to sidestep emotionally driven pitfalls. Now is the time to prepare your clients to avoid making rash decisions during the next downturn. Your Ticket Out of the Race to Zero The recent decision by several brokerage firms to stop charging commissions on stock and ETF trades confirms that pressure on fees continues to grow. More than ever, advisors need concrete ways to justify their worth to their clients. According to Vanguard’s Advisor’s Alpha study, coaching your clients is the best way to do that. The study, which attempts to quantify how advisors add value to client relationships, highlights behavioral coaching as having the greatest impact, adding 150 basis points on average to client returns every year.4 An advisor’s ability to steer clients away from costly, emotional mistakes is also a key point of differentiation. Guiding Clients Of all areas of life, money matters are among the most affected by our emotional biases. That’s because financial decisions are often complex and deal with subjects that involve a high level of uncertainty—two factors that magnify the influence of an investor’s emotions.5 In addition to foundational strategies of diversifying and rebalancing portfolio assets, consider these tips to help clients deal with emotional stumbling blocks: 1. Talk to clients about cognitive and emotional traps. Use real-life examples so these concepts sink in. It’s one thing to read about the anchoring bias, but another to see for the first time just how affected our daily lives are by it. Start with the more common biases first, including these top five:6 Overconfidence bias Confirmation bias Anchoring bias Loss aversion bias 2. Plan carefully now to avoid emotional decisions during the next crisis, when feelings of panic can overtake a client’s rational thoughts. In your planning meeting, develop an Investment Policy Statement that governs decision making around when to buy, sell, or hold an investment. Discuss the importance of trusting in the process and sticking with the plan. 3. For clients with an unquenchable desire to invest with their gut instincts, suggest setting aside a small amount of “side money” for that purpose. The amount should be insignificant to their well-being—perhaps 1 to 2% of savings. Encourage your client to keep a record of how their reactive/intuitive decisions went. 4. It’s always a good idea to remind clients of the benefits of diversification and asset allocation. You may feel like they already know, but a reminder, especially during periods of volatility, can only help. Our Keep Calm and Remain Diversified program can help. Conclusion The better you understand your client, the more likely you’ll be able to anticipate where that client will experience an emotional or cognitive bias, and the more adept you’ll become at short-circuiting those destructive thought patterns. Over time, your client will see the value of your financial coaching, which will build trust and loyalty. It takes time to teach clients about the traps of emotional investing, but it’s an investment that will pay off for the relationship in the long run. Please visit AMG’s Investment Essentials for more information on cognitive and emotional traps. To learn more about behavioral biases, see our blog on the herding instinct and our primer on behavioral finance. 1Barry Ritholtz, “Investors’ 10 Most Common Mistakes,” Washington Post, July 11, 2012. 2“Quantitative Analysis of Investor Behavior,” Dalbar, December 31, 2018. 3“Investor Returns vs. Market Returns: The Failure Endures,” James Picerno, Seeking Alpha, published September 21, 2017, https://seekingalpha.com/article/4108688-investor-returns-vs-market-returns-failure-endures. 4“Vanguard Advisor’s Alpha: Quantifying your value to your clients,” The Vanguard Group, 2016, https://static.vgcontent.info/crp/intl/auw/docs/resources/adviser/Vanguard_Advisers_Alpha_Quantifying_your_value_to_your_clients.pdf?20180301%7C083814. 5“Emotions and Decision Making: An introduction,” Prasad Ramani, CFA Institute, April 10, 2019, https://blogs.cfainstitute.org/investor/2019/04/10/emotions-and-investment-decision-making-an-introduction/ 6“5 Biases That Hurt Investor Returns,” Peter Lazaroff, Forbes, April 1, 2016, https://www.forbes.com/sites/peterlazaroff/2016/04/01/5-biases-that-hurt-investor-returns/?sh=6533ecf7d4ac.