Be your clients’ best info source

As concerns about the European debt crisis continue and as signs emerge that the economic recovery is slowing, it’s a good time to think about how your clients might be reacting to what they are hearing and seeing and what you can do to give them some perspective. You can do this by helping them take a step back and apply a proper dose of some needed context. Let’s start by drawing on some broad concepts from behavioural finance.

The traditional theory of markets – equity, bond, currency, credit, commodity, etc. – is that they are highly efficient. Specifically, each market always has sufficient information to set the appropriate price for whatever it trades. The appropriate price takes into account all of the factors that should enter into the price – mainly supply and demand but also a myriad of other factors such as regulatory issues, technology developments, barriers to entry and trade, political issues and overall economic and financial market conditions. Underlying the theory of efficient markets is the assumption that market participants – and others – behave rationally. Behavioural finance introduces the idea that emotions may play as large a role as facts in market behaviour. By implication, the role of rationality in decision-making is reduced.

Investors’ emotions can be driven in large part by the information available to them. I am convinced the increasing credence of behavioural finance has arisen partly from both the quantity and the quality of information now readily available to investors and its role in their decision making. In theory, more information is a good thing. More (and faster) information should enable better and more efficient investment decisions. In practice, there is evidence to suggest it doesn’t necessarily work that way.

Advances in information technology have made it possible to generate and distribute more information – and to distribute it faster and more widely – than most individual investors can comprehend, let alone usefully apply to investment decisions. Too much information in this context may be analogous to what some retailers are discovering: Too much choice on the shelves often leads to consumer confusion and potentially fewer sales.

Another issue relates to the quality of the information itself. While technology enables the near-instantaneous generation of information and enormously sophisticated analysis, it does nothing to ensure that information is accurate or perhaps more importantly that the analysis of the information is sound. Furthermore, the instantaneous nature of the transmission of information has led some to believe that there are also instantaneous solutions to economic and financial market problems. More often than not, there aren’t.

Let’s take the European debt crisis as an example. There is no question that it is a serious issue. A number of countries (notably Portugal, Italy, Ireland, Greece and Spain) have very large and unstainable government budget deficits. It is also the case that in some instances, governments wrote the book on how not to handle fiscal policy – running deficits when they should not have, being less than forthcoming in their published data about how big the deficits actually were, and financing some of these deficits off the government’s balance sheet, away from the public eye. What also makes the matter serious from a market point of view is that the crisis has been a surprise to markets. Markets hate surprises at any time, but they especially hate unpleasant surprises so soon after the global financial crisis and economic recession.

I believe the matter was made worse (or, worse than it needed to be) by the public response of the European leaders whose job it is to deal with it. Early on, it was suggested that the International Monetary Fund (IMF) be asked to intervene to help solve the crisis. While the IMF has been a target of criticism in recent years, one thing the Fund does well is to go into a country with a government deficit and debt problem, bring some money from the IMF member nations to help and use the big stick of not getting any financial help unless the country makes the changes necessary to fix the problem. Initially, the leader of one large European country poured cold water on the idea saying that bringing in the IMF would represent a blow to Europe’s pride. The problem with this kind of public statement is that markets are generally pragmatic. Their view is that if you have a problem and a possible way of solving it, you should take it. Bringing ‘European pride’ into the discussion roiled markets. Fortunately, reason prevailed and the IMF does have a role in dealing with the crisis. Other European leaders added to the problem by airing their differences in public and taking much longer than would have been ideal in finally acting.

Here is where the information problem came in. It‘s not that the reports of public disagreements weren’t true. It was that the longer they went on, the more there was an opportunity for the analysts and commentators to muddy the picture. Some lamented that Greece couldn’t devalue its currency as a way out of the problem and others suggested that Greece should leave the Euro zone so that it could devalue. Others forecast the end of the Euro completely. The problem with this sort of commentary is that it often contains half-truths. Yes, Greece could have effectively reduced the burden of its external government debt if it could have devalued its currency. But, doing this would have done nothing to deal with the actual problem – too much government spending and too little government revenue. And the widely-perceived benefits attributed to the Euro’s existence suggest that those who are forecasting its demise have utterly underestimated efforts that would be made to keep it.

The European leaders did finally act. They created a fund of approximately 500 billion Euros (with an additional 250 billion Euros from the IMF) to ensure that funding would be available to the governments in difficulty. But here, too, there has been an information problem, with the culprits again being the analysts and commentators. One very successful Canadian investor was quoted in the national media describing this fund as a failed bail out. I think he missed the point. The fund was created to ensure that the governments in question have access to required financing when they need it, at a cost that would not be so prohibitive as to make their situation worse. It is not and was never intended to be the solution to the problem. The solution is for the governments involved to make the necessary tax and spending changes to get their budgets on a sustainable basis. And, returning to a theme I mentioned earlier, the solution will be ongoing for a few years, i.e., there are no instant solutions.

So, you have clients saving and investing for retirement. They have already been rattled by the extraordinary market downturn in 2008 and early 2009. The rebound through much of 2009 might have come close to convincing them that things were roughly back to normal and then the European deficit and debt issue surfaces and their emotions are once more raw. What do you do?

Of course, there is no point suggesting that your clients stop reading/listening to/watching the financial news. It is all around us. You could however, suggest that they pay attention to a select number of sources in order to get a more balanced view. You could follow your own advice and develop as balanced a view as possible and impart that to your clients. Remind your clients that the basics of investing haven’t changed: have a written plan; develop a specific asset allocation that best meets the individual’s needs; establish a conservative savings/spend rate; be patient; and be realistic. Perhaps you should tell them the real story of the European debt crisis. It occurred because governments spent more than they took in, year after year. And then they tried some shortcuts to get out from under the problem. They didn’t work. And, solving it will happen only the old fashioned way. Spend less. Collect more taxes. Slow, sometimes painful but virtually guaranteed to be successful.

Information technology has democratized the generation and distribution of information. In general, democratization is a good thing. Allowing anyone to have their say on any topic and to be heard at least by some, is a fundamental part of democracy. We should embrace information technology and continue to push forward its incredible potential. But let’s also be careful not let it, and the content that follows get in the way of the basics of the economics of retirement. The fundamental rules around saving and investing for retirement are not subject to technological change.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.