Perhaps the main role of a professional advisor is to ensure that clients avoid “The Big Mistake.” Of all the advances in the field of personal finance, there may be none more important than certain fairly recent discoveries in behavioural finance.
Behavioural finance is the study of how emotional decisions caused by human factors lead to poor investment choices and reduced investment returns. A growing body of research demonstrates how this human side of investment decision-making has a major impact on portfolio outcomes. Despite this, there’s no material in any licensing textbook to teach advisors how to stay the course and deal with problems caused by their clients’ emotions.
The research that these thought leaders conduct is about as compelling and important as any. They have shown that large proportions of society are susceptible to decision-making quirks that are often self-destructive. This evidence presents an obvious challenge for advisors. On one hand, changing behaviour can be emotionally difficult, so people instinctively resist it. On the other, not changing can lead to considerable losses. When people are confused and anxious, they tend to do irrational things such as sell low and buy high, even as they profess to be sensible long-term investors.
On the surface, many consumers have sufficient knowledge of capital markets to make adequate financial decisions. Despite this, the data on fund flows shows massive net redemptions when mutual fund values are dropping and massive net sales when markets are on fire. If the phrase “buy low, sell high” is such a trite little truism that anyone can understand, why do so many people do just the opposite?
Similarly, if the principle of diversification is so basic that it is seen as a motherhood issue that everyone understands and agrees with, why were so many portfolios wildly overweight in technology when the bubble burst at the turn of the millennium? There is considerable evidence of home-country bias everywhere on the planet.
Why do citizens of every nation on earth invest disproportionately in domestic stock markets? If they’re all seeking the best possible risk-adjusted return, it should be obvious that they can’t all be right in how they’re investing. It seems the quest for performance can easily take a back seat to convenience and familiarity.
If left to their own devices, consumers will frequently make emotional decisions during market swings and manias, even if they later acknowledge in hindsight that they were not making logical decisions at the time. As such, an advisor might be able to apply the teachings of behavioural finance to help clients maintain a better sense of perspective. That, in turn, should lead to better decision-making.
Qualified advisors can be useful in offering reasonable counsel that would prevent self-destructive tendencies. Standup advisors understand this intuitively. Despite this, advisors receive no formal training in the field of behavioural finance before they start in the business. Licensing exam course material does nothing to explain behavioural concepts such as anchoring (relying too heavily on the first piece of information offered) or loss aversion (preferring to avoid losses over acquiring equivalent gains), even though these and other emotional and intellectual blind spots go a long way in explaining investment experience.
Advisors should understand that they need to offer advice from the client’s perspective and that the client is going to feel overwhelmed by some of the complexity and uncertainty of capital markets. University courses leading to an advanced degree in financial planning, therefore, also need to add an entire body of work to their course material dealing with tangible case study approaches on how to assist clients in staying the course and avoiding “The Big Mistake.”
Imagine the good that qualified advisors could do if educators actually taught them how to apply solutions to these problems.
This is an excerpt from The Professional Financial Advisor IV (Insomniac Press), a guide that explores the complex relationship between investors and their advisors.
John De Goey is a Portfolio Manager with Industrial Alliance Securities Inc. and the author of The Professional Financial Advisor IV. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund. The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies.
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