Essentially, the concept behind behavioral finance is that whenever emotions get involved, investors get hurt.
“Behavioral finance tries to stop you doing the wrong things at the wrong time, both in times of fear and greed,” says Robert Patrick, director of education and development at Raymond James' private client group in St. Petersburg, Fla., adding that short-term market behavior is almost always emotional.
His evidence? A Dalbar study that looks at investing over a 20-year time horizon. The magic number is 6%. Whatever you would have earned by leaving your money in the S&P 500 for 20 years, take 6% off that if you ever touched your money. If a passive investor earned 10% overall, an emotional investor would walk away with just 4%.
Likewise, while an investor wouldn’t have made a cent leaving his or her money in the S&P 500 over the past decade, impulsive moves to improve matters would have more than likely resulted in a loss, Patrick says. “The past market is a great example,” he says. “Many people who panicked and sold out in 2009 subsequently missed the 49% run up. Those with 10 years left before they retire weren't thinking about that.”
The message for advisors is simple: Focus clients on their long-term goals or they’ll end up in trouble. The choice here is to do so reactively by talking panicked clients off the ledge when things go belly up, or by taking the initiative and making the long-term nature of the plan its most attractive feature.
Patrick is hoping to accomplish this through an association with Frank Murtha, whose website marketpsych.com contains risk profiling tools that go far deeper than how a person feels about the market’s ups and downs. I took the test for investors, which is free. It delves into areas including conscientiousness, emotionality, extraversion, openness, agreeableness and confidence, to gauge how an individual reacts to external stimuli and whether he or she tends to follow herd behavior or not. Using this depth of information, advisors can engage their clients in the investment process on a personal level, ironically delving into their emotional lives to create a rational, long-term strategy.
It’s not an easy process: Investors’ current confidence tends to be based on their most recent market experience, so advisors have to talk through that to get to constant truths. “The way to do it is to recognize the pain they now feel and then ask open-ended questions that get the client back to what they want to accomplish, what their timeframe is and if the current plan is still viable,” Patrick says.
Refocusing people on their long-term aspirations makes them more positive about their plans paying off in the end, he says. And advisors always have the fallback argument that “those who didn’t overreact are now in a far better position than those who did.”
Clients will, of course, be skeptical, but advisors who stick to their guns on long-term planning will win the day. “It’s a difficult discipline because you’re telling clients to do exactly the opposite of what their gut is telling them to do,” Patrick says. “But the profiling process reveals clients’ true emotional tendencies and that’s an important discussion.”