From the very first investment mania in 1637, where single tulip bulbs sold for more than 10 times the annual income of a skilled craftsman, we’ve known that emotion plays a strong role in driving investor behavior.
In a recent study by Todd Feldman, a finance professor at San Francisco State, he isolates which of the specific emotional and behavioral biases are most destructive to investors. We’ve observed that when financial advisors are more aware of the psychological and behavioral consequences of their clients’ behavior, they can step in and intervene, protecting them from the consequences of their behavior. This also allows advisors to build a stronger partnership with their clients.
We’ve all seen the studies that document the destructive effect of behavioral biases on investment returns. The landmark 2009 DALBAR study, “Qualitative Analysis of Investor Behavior”, that showed that over a 20-year period, the S&P 500 returned 8.4 percent, but the average equity fund investor returned only 1.9 percent. Or the 2009 study by Brad Barber, “How much do investors lose by excessive trading?” that documents an annual loss of 3.8 percent for trading-addicted investors who can’t stop themselves.
With the increasing attention to behavioral economics, we are also learning about some of the more prevalent and emotion-laden investment flaws:
Loss aversion: where investors feel the pain of loss TWICE as much as the pleasure they derive from an equal gain.
Recency: Putting too much weight on the current environment when making decsions about the future
The disposition effect: Selling winners too early, and keeping the losers and ending up with a portfolio of cats and dogs.
Anchoring: The common human tendency to rely too heavily on one piece of information when making a decision.
And others: e.g. status quo bias, the endowment effect, regret aversion, overconfidence, etc.
The Most Destructive Behavioral Bias
Feldman’s results indicate that the most destructive behavioral bias that an individual investor uses to make investment decisions is recency. When investors make predictions about the future based on what is happening at the current time, they underperform by 7 percent per year over the long-term. In addition, excessive trading due to a separate bias, loss aversion, when downturns occur and when investors become fearful, compounds bad performance
How Financial Advisors Can Help
The data suggests that financial advisors can help individual investors by:
- Building a investment plan that diversifies funds across a broad spectrum of asset classes,
- Rebalance occasionally,
- Be watchful of the bad investment behaviors that tend to influence investors during stressful investment periods, and counteract these corrosive behaviors with: insightful and powerful questions, discipline, patience, as well as a heavy dose of investment humility.
It may not seem like much, but if a financial advisor can help their clients avoid these mistakes, and as a result protect portfolio performance to the tune of 3 percent, 4 percent, 5 percent, 6 percent, or as much as 7 percent per annum, the financial advisor is doing a great service to their clients and reinforcing their relationship, creating a stronger bond of trust going forward.
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