Save clients from emotional mistakes

If markets tank and your phone doesn’t ring, that’s reason to celebrate, right?

Not always.

Hopefully, your clients aren’t calling because they’re comfortable with their portfolios. Others may be blissfully unaware.

But some could be too embarrassed to admit how scared they are.

Worried clients need to know that honesty matters more than keeping calm during rocky markets. Chris Ballanger, director of wealth management at Richardson GMP in Toronto, says: “When somebody calls me and they’re worried, I thank them for the call,” he says. “If you’re on top of how people feel, [they] won’t reach the panic point.”

It’s your job to make sure clients are comfortable reaching out, no matter how they feel.

“You can’t tell people they’re wrong or be dismissive, whether they tend to overreact or under-react to significant market events and news,” says Frank Danielson, senior financial planner at Assante Capital Management in Vancouver, who emphasizes there’s no standard response to market moves. If clients are stressed, try to understand their emotions, and then offer perspective.

But comforting clients can be a delicate process. Danielson suggests checking your own opinions at the door and empathizing with clients’ fears and concerns (see “4 ways to bust your own biases”).

Recognize that you shouldn’t try to change client reactions, and that any client can be emotional, says Ballanger. He’s spent the last decade researching investor behaviour and finds that, no matter how financially literate a client is, “you’ll always have the logical brain versus the reactive, or primitive, brain.”

Ballanger cites a 2016 BlackRock report looking at the growth of a hypothetical $100,000 investment in the S&P 500 index over the last 20 years. Such an investment would have grown to $500,000 if left untouched. But, between 1996 and 2015, the average investor earned 2.11% in annualized returns, while stocks averaged 8.19% and bonds averaged 5.34%. BlackRock attributes the average investor’s underperformance to emotional market exits and entrances.

The best way to help clients avoid this type of underperformance is to recognize when they’re exhibiting common investor weaknesses, and to plan around them. Here’s what you need to know.

Understanding investor reactions

There are more than 100 psychological biases that can affect financial decisions. These include anchoring, overconfidence and loss aversion (see “Biases you should know“).

These biases can lead to overreaction and under-reaction when it comes to gains, losses and market news. “The efficient market hypothesis [assumes] markets are always calm, perfectly calculated and computer-driven,” says G. Ed Stubbins, CFA, partner at Fuller & Thaler Asset Management in California. But there are two reasons this hypothesis fails: “Investors tend to overreact to historical negative information and under-react to new positive information.”

When the markets dropped in the summer of 2015 and again that December, it created a lot of overreaction. “Following that, as markets improved, we saw a lot of under-reaction to opportunities that popped up in Q2 2016,” Stubbins says, and that has continued. As of March 2017, both the S&P/TSX Composite Index and S&P 500 had continually improved since Q2 2016.

Despite these gains, Stubbins adds, it can be difficult for now-cautious and fearful investors to stay invested or pick up opportunities. Stubbins doesn’t try to time the market, but says opportunity-seeking investors should watch several indicators. “In particular, significant and unusual insider buying by officers of companies” can signal potential upside at such companies.

Between the summer of 2015 and early 2016, Stubbins says there was a pick-up in insider buying activity across all sectors, which tends to occur when the market sells off. To benefit from positive, underlying trends, clients just need to hold on.

Overreaction to market dips, both during and after they occur, is largely caused by biases like fear of losses, says Stubbins, while under-reaction to both positive or negative news is often caused by overconfidence and anchoring.

Say a client is part of an employee share program and refuses to sell his company’s stock, even though it’s underperforming based on poor fundamentals. Danielson sees this regularly, saying, “There can be a lot of emotions to deal with.” These can include fear of regret if the stock continues to gain after selling, or being wary of paying taxes on significant gains. In any case, you can highlight that, no matter the attachment, a dip in share price can mean further downside risk.

“If a client is frozen, we try to have them commit to a transition strategy,” says Danielson, where you may reduce their position each quarter to end up at lower or zero exposure by the end of the year. Using price targets to determine when you’ll sell is riskier, because “they may never happen”—a stock might not drop another 5%, but could drop 3%, still warranting divestment.

Overall, help clients strike an emotional balance, says Kelly Peters, CEO and co-founder of behavioural economics research firm BEworks in Toronto. You don’t want them to overreact to bad news or opportunities, but you want them to recognize when portfolios need to change.

To avoid this, Peters suggests creating an investment policy with clients, agreed to at the outset of the relationship, that sets out when their portfolios and holdings should be reviewed, based on objective calculations and whether goals are being met. She adds, “active rebalancing strategies [should be] defined by strict, established rules.”

For his part, Ballanger creates a statement based on a client’s tolerance for risk, volatility and other measures. It’s is separate from the client’s KYC document, he adds. It includes a summary of her investment preferences and knowledge, and lists what Ballanger and the client discussed. The client needs to approve the statement and, if any issues arise down the road, Ballanger can refer to it.

How you can help

To help clients identify their biases, Danielson uses an online behavioural finance tool offered by Financial DNA, a fintech solutions company. Clients answer 46 word-association questions and, upon completion, both he and his clients receive a six-page final report. Some of the details cover a client’s behavioural weaknesses and strengths.

Reviewing this report together enhances the discovery process, he says, since it lets him see how new clients make decisions. Not all clients agree to take the assessment, says Danielson, but a majority find it enlightening.

The tool assesses whether they like a lot of control or can cede control, “and [whether] they have a structured or spontaneous personality,” Danielson says. Typical risk tolerance questionnaires don’t tell you everything you need to know about a client’s perceptions, emotions and risk capacity, he says, so the advisor has to fill that gap.

Danielson will discuss the assessments with new clients for 10 to 15 minutes. He also shares a copy of his own Financial DNA report, showing that he, too, is human, with regrets and emotions about losses. For example, Danielson’s report shows he likes to create structured plans and co-operate with clients, but he needs to be aware that he could focus on gains more than losses if he’s not vigilant (known as the disposition effect bias).

When it comes to investing, he prefers to take a buy-and-hold approach with clients because it’s less emotional, and he doesn’t pick stocks. “Tactically moving from one bucket to the next [can result in] clients, and even advisors, having biases and making mistakes. We have a strategic asset mix and investment plan,” Danielson says.

He continues to educate clients about markets and, every three years, he reviews their financial DNA.

Ballanger’s approach is similar: while he makes tactical portfolio moves, all of his clients have investment statements covering suitable asset mixes. “No matter what markets are doing, you rebalance to stay within your set asset mix,” he says, as opposed to trading on market movements or news.

When markets are jumpy, Ballanger discourages clients from anchoring based on short-term trends. He reminds them of the bigger economic picture: if they’re not running out to sell their home based on last month’s price data, they should be thinking twice about dumping their portfolio, he tells them.

But, he adds, “if I have misjudged somebody and they’re more affected by downturns or volatility than I expected, I may take their equity exposure down 5% or 10%—not 50%—if it will help them sleep at night.”

Client behaviour can seem varied and unpredictable if you don’t properly diagnose their biases, Ballanger adds. Someone could under-react to small losses for a number of years, but when forced out of their comfort zone due to the major decline of an asset, “they’ll tend to overreact and be super conservative.” They’ve revealed their true bias.

Sudden emotional swings are more likely if clients take on too much risk over long periods, he says, noting that taking on too little risk can also have an effect. When clients are comfortable with their portfolios, they make more rational reactions and decisions.

A client’s emotional responses can also be multiplied by personal challenges, warns Danielson, so stay up-to-date on their lives. “If clients are having relationship problems while markets are very good or very bad, for example, that can escalate their levels of anxiety or excitement.”

4 ways to bust your own biases

Advisors aren’t immune to cognitive biases, says Chris Ballanger, director of wealth management and advisor at Richardson GMP. “A lot of advisors tend to be, by nature, optimists. [We] believe in a better future and don’t buy investments for clients that [we] don’t think will be better down the road.” But, “always ask, ‘What’s the impact if I’m wrong?’”

To gain perspective, follow these tips.

• When choosing investments, always get a second opinion from a partner, colleague or manager—especially when clients are stressed out or difficult.
• Instead of managing portfolios yourself, work with portfolio managers who have good track records. Your job is to emotionally coach clients, not make tactical, short-term decisions.
• Test your own emotional responses to markets, and discuss your own biases with clients to encourage reciprocal honesty.
• Research behavioural trends regularly and share client-friendly resources.

People might say it’s the right time to buy in down markets, but going through these processes can help you make sound decisions. Also, consider what’s right for clients versus what will boost their returns.

Biases you should know

Anchoring: where a client focuses on one piece of information (e.g., a stock’s past price or its reputation) and ignores all other relevant details, such as its current performance

Overconfidence: where a client views his abilities too favourably and has to work hard to overcome this

Loss and disappointment aversion: where a client will do anything to avoid loss or disappointment, including selling at low prices, avoiding moderately performing stocks, and avoiding stocks that are under-valued

The January effect: where stocks go up at the beginning of the year due to investor optimism, often far more than they should, and then correct

Low-volatility anomaly: where clients believe high-risk stocks offer the best rewards versus low-risk stocks and portfolios, even though the latter tend to perform better over the long term

Confirmation bias: where a client only collects evidence that supports his beliefs and minimizes contradictory evidence

Cognitive dissonance: where newly acquired information conflicts with a client’s pre-existing notions, causing discomfort and stress

Source: SEI Investments Canada