Advisors, behavioral finance provides an easy framework to keep clients from making poor investment decisions.
Investment theories like Harry Markowitz’ Modern Portfolio Theory and Eugene Fama’s Efficient Market Hypothesis help us understand how the markets work, but they only go so far. Interestingly enough, Markowitz and Fama left investor behavior out of their theories.
In the real world, human biases can have a much greater effect on investor returns than mathematics. Biases are subconscious beliefs that affect human behavior. While biases differ from individual to individual, millions of people acting on the same biases at the same time have created some of the world’s great investment bubbles: the tulip bubble of the 17th century, the dot-com bubble of late 1990s, and in recent years, the meteoric rise of Bitcoin.
The study of human biases in the investment process is called Behavioral Finance. Unlike investment theories, behavioral finance takes human nature into consideration by acknowledging that:
- Investors are “normal,” not “rational”
- Markets are not efficient, and
- Investors do not use modern portfolio theory to create investment portfolios
Why Advisors Should Care About Behavioral Finance
For more than 25 years, Dalbar has researched and compared investor performance to the performance of broad market indexes and has found that investors earn less year after year. In one study they looked at investment returns for the 30 years ending 2013. During that period, the total return of the S&P 500 was 11.1%. The average stock mutual fund investor earned 3.69%.
Of the difference, 1.4% is mutual fund expenses and the rest is a result of the investor’s emotions which precipitated poor investment decisions.
How Advisors Can Help Their Clients Today
While some investors believe they can “go it alone,” recent studies have determined that the opposite is true.
In 2013, Merrill Lynch released a study of the value of different services provided by financial advisors that found that behavioral coaching from the advisor added 100 to 400 basis points to the investor’s return.
In 2017, Paul Kaplan and Dave Blanchette of Morningstar found that investment strategies implemented by advisors could add “significant” value to investor returns.
Three Ways Advisors Can Manage Client Behavior
Use this framework to stop clients from making poor investment decisions.
The role you play in keeping your clients from making unwise decisions cannot be overstated. You play a critical role in your clients’ financial well-being by coaching them and shaping their behavior. To do that, create a client experience that focuses your clients on life goals tied to long-term investing instead of focusing on short-term investment performance.
Goals-based investing causes clients to shift their focus from the performance of their entire investment portfolio to the performance of the portfolio allocated to each individual goal. It reminds clients why they’re investing and enables them to visualize investment risk and progress by time frame instead of total portfolio value.
It should come as no surprise that your biases also influence the recommendations you give your clients. In order to moderate the influence of your biases, adopt an objective, time-tested investment process and strategy that you use with each and every client. Within that process, rely upon a small number of holdings that you know well and build investment portfolios that provide your clients with competitive performance during rising markets and guardrails during declining markets.
Investors will always face challenging investment markets. Your job is to 1) recognize the part that client emotions play during volatile markets, 2) focus clients on the things that matter like their life goals, and 3) protect them from the human tendency to make poor investment decisions.