Most good advisors are used to playing psychologist—helping clients understand and overcome irrational impulses in order to make sound investment choices.
“That’s what clients are really paying for,” says Todd Feldman, a partner with Behavioral Finance Investment Advisors, in San Francisco, and an assistant professor of finance at San Francisco State University. “They need help in getting around their irrational behavior.”
Now, a Allianz Global Investors white paper authored by UCLA professor Shlomo Benartzi is offering several tools drawn from the field of behavioral finance to help advisors help their clients.
The tools address three familiar challenges: investors’ paralysis, lack of discipline and distrust of their advisors. Most decisions that humans make, the paper notes, are based on intuition rather than logic. The tools acknowledge the way the mind operates in order to help improve behavior.
A major challenge for investors and advisors is paralysis. The current environment, in which huge amounts of money remain on the sidelines in the wake of the financial crisis, is an apt example of investors’ inability to take action when action is needed, Benartzi says.
“A lot of the money on the sidelines, in my opinion, is following the ‘the buy-high-sell-low strategy, which is quite unfortunate,” says Benartzi, who is chief behavioral economist at Allianz’ Center for Behavioral Finance.
The psychological principle in play when investors are “paralyzed” is known as loss aversion: For example, investors today are still feeling pain from recent losses, and they are afraid—despite the market’s well-established recovery—of incurring more losses.
Benartzi’s solution builds on dollar-cost averaging, which can be used to overcome fear of re-entering the market all at once. But in what he refers to as “dollar-cost averaging 2.0,” his solution tackles another element of paralysis: procrastination.
To help investors overcome procrastination, Benartzi suggests that advisors ask them not to enter the market immediately but rather to pre-commit to entering at a certain point in the future. If the client agrees, he or she can then be asked to pinpoint a date when they would feel comfortable making the move. The result is that the once-balky client feels both committed and in control.
Another common investor foible has to do with making impulsive investment decisions, Benartzi notes. To help clients avoid this pitfall, Benartzi recommends what he calls “the Ulysses strategy.” In Greek mythology, Ulysses withstood the Sirens’ deadly songs by having himself tied fast to the mast of his ship ahead of time.
Financial advisors can invite clients to use similar forethought in pre-commiting to a rational investment strategy. Part of the client-adviser discussion should lead to agreement on what action will be taken in different scenarios—for instance, if the market should move up or down 25%.
Formalizing the agreement with a non-binding commitment memorandum can help advisers to remain disciplined as well. After all, advisors have the same mental wiring as clients, Benartzi notes.
Benartzi’s paper also deals with the damage to clients’ trust of their advisors that has resulted from the financial crisis. A July 2010 Gallup Poll found financial institutions rank 11th of 16 institutions in terms of public trust, it notes.
An effective way to rebuild trust using behavioral finance insights is to demonstrate competence and exhibit empathy, according to Benartzi. One counter-intuitive way for an advisor to demonstrate competence is to admit the role luck has played in achieving results for the client. Honesty resonates strongly and reinforces trust in clients, Benartzi says.
“I think the more you actually admit luck, the more you can brag about good outcomes—and explain when performance is actually due to bad luck,” he says.
Exhibiting empathy is a good idea as well. That includes contacting clients frequently, especially in difficult times. And allaying clients’ embarrassment is worthwhile as well, Benartzi says. Rather than putting a client on the spot by asking: “Is there anything about our strategy that you don’t understand?” advisers might instead ask: Is there anything about our strategy that I can clarify?”
Finally, Benarzi addresses individuals’ disinclination to save. Part of the problem, he says, is our present selves’ lack of empathy for our older selves, who we practically regard as strangers. Allianz is working with researchers to develop a “behavioral time machine” for advisers and clients. The time machine will allow individuals to see age-processed “future” images of themselves.
Evidence suggests that when they do, they will save more in order to better provide for their future selves, Benartzi says.