The old Wall Street saying “financial markets are driven by two powerful emotions—greed and fear” is particularly relevant during turbulent times. Many individual investors are full of greed during up markets but fearful during down markets. However, as Warren Buffet acknowledges, overcoming fear is easier said than done. “There is no comparison between fear and greed. Fear is instant, pervasive and intense. Greed is slower. Fear hits,” Buffet has said. He’s also offered such sage advice as “Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”
Unfortunately, following this advice is difficult for many investors because it seems counterintuitive. This is where financial professionals enter the picture.
Financial planners and advisers face an especially challenging task in working with clients whose emotions and cognitive biases influence their behavior when faced with extended periods of boom or gloom. Investors often act irrationally during periods of stress that can lead them down the wrong path. For example, investors may fall victim to the disposition effect in which they tend to sell their winners too early, and hold on to their losers too long. However, financial professionals can play an important role in providing both financial and behavioral guidance in navigating within increasingly complex financial marketplace and helping investors from self-destructing if left to their own devices.
Some other behavioral biases, clients may suffer from are the following:
Loss aversion: Individuals tend to focus on downside risk when they invest in stocks. This feeling of loss can remain for an extended period. Many people who realize major losses during a market decline tend to avoid stocks and remain in cash because they perceive this is a safer strategy.
Anchoring: Clients often cling to a specific piece of information, which serves as a reference point that affects their future decisions. When clients anchor on a bad investment decision, they can be very risk and loss averse. Anchoring can result in both higher levels of worry and risk perception as well as lower risk tolerance, leading them to underinvest in stocks and overweight cash in their portfolios.
Negative affect: Research evidence shows a link between seasonal depression disorder and stock investing. When people become depressed during the winter months, they demonstrate a predisposition to have higher levels of risk aversion, which leads them to own fewer stocks and allocate more money to cash.
Financial planners often work with individual clients to develop an investment policy statement (IPS) that defines general investment goals and objectives and describes the strategies that will be used to meet these objectives. Thus, an IPS outlines general rules to be followed in managing the portfolio. However, the stress associated with volatile markets can result in irrational reactions by clients to change the asset allocations in their portfolios. For example, a client may want to reduce the allocation in stocks and increase the allocation in debt instruments or cash during a market downturn. Investors often suffer from short-term bias in which they emphasize short-term financial results.
Some clients have difficulty staying disciplined and following the agreed upon rules or guidelines in the IPS. Rarely does such market volatility merit a knee-jerk reaction. Here is where good advisers can add substantial value to their client relationships. When faced with periods of market turbulence, they need to advise their clients to stay true to their plans and to focus on long-term goals, not market timing. The value proposition of such advisers centers on client outcomes, not uncertain markets. In short, advisers need to remain disciplined even though their clients are not. By doing so, advisers can help their clients maintain a long-term focus instead of succumbing to short-term greed and fear.
This blog draws upon some concepts and strategies in the authors’ book Investor Behavior—The Psychology of Financial Planning and Investing (John Wiley & Sons, Inc., 2015) and their article “Understanding Behavioral Aspects of Financial Planning and Investing” published in the March 2015 issue of the Journal of Financial Planning, available here.
Professor of Finance
Bryn Mawr, Pa.
Assistant Professor of Financial Management