2006
PROCEEDINGS
How You Can Help Irrational Investors
Make Rational Decisions
Michelle L. Hoesly. CLU, ChFC
K
en and Tina were new clients. In reviewing their
current investments, I asked them about several
of their holdings. When I inquired why they were
invested in Mutual Fund A, they said that they had bought
it when the price was much higher, but they were going to
keep it until the price got back up to where they bought
it. Their prior advisor had suggested they buy it, but it had
only lost money for them. They also were sure that as soon
as they sold it, it would go up. Another of their holdings,
Mutual Fund B, they had been thinking of selling. When
I inquired why they were thinking of selling it, they said
they had made a lot of money on it and they’d like to
lock in their gain. They also had a little account that was
only holding one security that was an incredibly volatile
small company. When I asked them about that account,
they said that it was money they had inherited from Tina’s
grandmother and they were putting it into this really risky
stock because they figured they could lose it.
I expect that this conversation doesn’t sound much
different than many of the conversations you have with
your clients. In looking closer, many of things Ken and
Tina said don’t make sense on the surface. Why would
they think of selling a fund just because they had made
a lot of money on it? Why would they hold onto something until it broke even, especially if it might take years
for that to happen? Is it just coincidence that their trade
that didn’t work out was the advisor’s idea and the one
that did was theirs? Does it make sense that the small
amount of inherited money should be put in something
so risky?
In doing research for my dissertation, I became fascinated with an area of theory called Behavioral Finance,
that attempts to explain many of the things investors
do that appear irrational. The thing that most appealed
to me was Behavioral Finance had a very useable and
practical application in our daily work with clients. I’d
like to share with you some of the concepts of Behavioral
Finance and give you examples of how I use this knowledge in my practice. I’ll share with you some wonderful
sources of information so that if you find this interesting,
Michelle L. Hoesly, CLU, ChFC, is a 27-year
MDRT member with three Court of the Table and
three Top of the Table honors. With more than 20
years of experience in MDRT’s leadership, Hoesly
has served as a Chair on six committees and as
a Divisional Vice President three times. She is
currently Chair of MDRT’s 2006 Public Relations
Committee, and she is a member of the 2006 Top
of the Table Advisory Board. She is an MDRT
Foundation Diamond Knight and a member of its
Board of Trustees. Hoesly is a past president of the
Norfolk Association of Insurance and Financial
Advisors, and served as president of the Make-AWish Foundation of Virginia’s founding board.
Capital Resources
150 Boush St., Suite 701, Norfolk, VA 23510
Phone: 757.616.0600
E-mail: [email protected]
I/R Code: 4400.00
Cassette: A0622
MP3: MP0622
CD: C0622
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PROCEEDINGS
How You Can Help Irrational Investors
Make Rational Decisions (continued)
you can read in greater depth about both the theory and
application of some of these principles.
Most of us are familiar with efficient market theory
which essentially says securities that are publicly traded
reflect a fair price at all times. The price reflects all known
information. The challenge has been that although efficient market theory makes sense, it hasn’t been very helpful
in explaining actual investor behavior. Scholars have documented many areas where investor behavior appears to be
irrational. Most recently, behavioral finance scholars have
shown many of these seemingly irrational behaviors are
systematic and predictable. This field of study isn’t very old;
in fact Daniel Kahneman, a psychologist, was awarded a
Nobel Prize for Economics in 2002 for his work in this field.
Keep in mind that there is still controversy in the academic
field over the whole area of Behavioral Finance, but I think
that you will find, as I have, that it goes a lot further than
traditional economics and finance in helping to understand
our client’s behavior and in helping us develop practices
which will enhance building our client’s wealth.
Let’s look at my meeting with Ken and Tina. Their
wanting to hold Fund A until it breaks even is an example
of ‘anchoring’. This is where investors make decisions
based on a specific number, like the purchase price, or
break even point, instead of making the decision based
on their expectation of future returns. The second investment, Fund B, is an example of ‘disposition effect’, where
investors like to recognize gains, but they delay recognizing
losses. Frequently this causes investors to sell the winners
too early and hold the losers too long. Another of the
behaviors that this interview illustrated was that Ken and
Tina attributed their smart buy to themselves and their
losing buy to their advisor. This is called ‘attribution’ and
while it may be frustrating to those of us who are advisors,
it is common and poses some compelling reasons for documentation. So, what about the small inheritance investment? That is an example of ‘house money’. Investors will
often take on much more risk when they are ahead of the
game or using someone else’s money.
I am going to touch on a few of the behavioral anomalies the research has identified. I’ll give you a summary
of the concept and then go through examples from our
practice with tips on how you may deal with these. One
piece of research I found interesting because it focused
heavily on the ‘what to do in real life’ area broke these
irrational tendencies or biases into two categories: cognitive and emotional. Cognitive biases are a bias in the way
we think about something. Emotional biases are a bias in
the way we feel about something. Pompian and Longo
suggested when clients have cognitive or thinking biases,
we may be able to moderate that bias through things we
do. Emotional biases are more challenging and many
times we, as advisors, may have to adapt to the client’s
bias. They also postulated that we should deal with these
biases differently based on the level of wealth of the client.
I am going to share their grid with you, but want to have
you look at it with the understanding that this is just an
idea on how to apply our knowledge of these biases.
The way to use this grid is to determine if the bias is
in the way they think (cognitive) or in the way they feel
(emotional) and then to determine if they are of high
wealth or low. For example, if I have a client who is
very wealthy and has great aversion to loss (which is an
emotional bias), then this chart suggests that I might be
more successful in using methods that adapt rather than
using methods that moderate their bias. So as I discuss
some of the areas of recognized behavioral biases, I will
also offer methods that I use both to moderate and adapt.
Let’s start out by doing a simple game. Consider a
simple coin toss. If it shows tails you lose $1,000, and
if it shows heads you win $X. What would $X have to
be for this gamble to be attractive to you? Studies show
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PROCEEDINGS
How You Can Help Irrational Investors
Make Rational Decisions (continued)
that it is common for people to ask for more than $2,000
in order to balance the risk of losing $1,000. This is an
example of loss aversion. Traditional theory says that a
‘rational’ investor will get the same amount of pleasure
out of a $1,000 gain as he gets pain out of a $1,000 loss.
In other words, losses and gains of the same magnitude
evoke pleasure and pain of the same magnitude. However,
when researchers measured how people actually felt about
losses and gains, they determined that most investors felt
substantially more pain on losses than pleasure on gains.
In fact, some research shows that the pain is 2 ½ times as
great. There is a concept which illustrates this which is
called a utility curve.
more likely to hold a bad investment and accept more risk
than recognize the loss by selling it out.
So let’s look at some examples of ways that we as practitioners can moderate or adapt to our clients (and our own)
loss aversion.
Ways to moderate
Avoid narrow framing. One of the most common
behavioral errors is called narrow framing. Essentially
it says that people tend to make better decisions when
they take a broader view. Looking too narrowly, increases
the chance of making mistakes. This begins with the
asset allocation and follows through with time horizons.
Investors too often look at the returns of a single investment instead of returns of the broad portfolio. And they
look at them too frequently. We need to help our clients
remove the emphasis on being right in very specific choices
and instead have them focus on how we are tracking the
long term objective. This is particularly true if we have set
up a portfolio of uncorrelated assets. If we have, there will
always be assets which appear to be underperforming in the
short run. We need to educate our clients about how to
view a portfolio and the role these uncorrelated assets play
in reducing risk. Most clients don’t know how to evaluate
a portfolio, it is up to us to manage their expectations by
training them what to look at, and how often. While I
report my client portfolios quarterly, the page which I have
them focus on is the page in the report which graphs the
long term results of their combined portfolio.
Get agreement on Real versus Relative Return. Real
return is where you and your client agree on a long term
target return, such as 6%, and then you measure against
that return. Relative return is where you measure the
client portfolio performance against an index, such as the
S&P500. If you don’t have a clear understanding of the
difference between real returns and relative returns, and if
you don’t know how to make sure your client knows the
difference, the tendency is to judge the portfolio on relative returns when the market is soaring, (how am I doing
versus the market), and on real returns in down markets,
(am I losing money). In other words, your client may force
You’ll notice that the curve rising above zero is
increasing, but at an ever slowing rate. That means that
while we get more pleasure out of getting a 20% return
than a 10% return, we don’t get double the pleasure. But
even more interesting is what happens below zero. You’ll
notice the curve drops off dramatically at zero. This
means that even small losses are very painful and the
steepness of the curve shows that we do not feel losses
proportionally to how we feel gains. Now, you and I
know that from our practices, but when we understand
the financial theory of this, we can use it to help clients
either ‘moderate’ their reaction or we can ‘adapt’ our
practices with this in mind.
Another related finding to loss aversion is that people
will take on more risk to avoid a certain loss. When
people were given a choice of a certain loss of $500 or a
50% chance of losing $1000 and a 50% chance of staying
even, they overwhelmingly picked the 50/50 deal. People
do not want to embrace a sure loss. Our clients may be
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PROCEEDINGS
How You Can Help Irrational Investors
Make Rational Decisions (continued)
you into a losing situation by expecting your portfolios to
outperform the market when the market is up, but then
switch and expect no downside when the market is down.
The best way to manage that expectation is to make sure
that you force the client to choose between an objective of
relative performance or real return. One way to do this is
to have questions in your suitability form which highlight
real return compared to relative return choices. However,
the reality it that you and I rarely control what questions
are on the suitability forms we use. However, most broker
dealers do not frown on you asking additional suitability
questions. A simple explanation such as the one I just
gave, along with a question, do you want our portfolio to
focus on getting a 6% fixed return objective, with only
moderate variation or do you want our portfolio to focus
on performing well compared to a stated blend of the stock
and bond market? If you pick the second choice, there
may be a time when you have lost a great deal of money
and yet I will tell you that your portfolio is performing
excellently, because you will have performed better than
the market portfolio.
Have methods by which you manage risk and discuss
those with your clients every time you meet with them.
Think of one of the mutual funds you frequently recommend to clients. Now, do you know what the prospectus
on that fund says regarding how much money the portfolio manager can hold in cash? Can the manager go
100% to cash, 50% to cash? My guess is that if I asked,
very few of you would know the answer. We expect other
managers to have incorporated methods to manage risk
into their investments, but we probably haven’t taken
an adequate amount of time managing risk on the portfolio level and explaining how we are doing that to our
clients. Some of the ways that I manage portfolio risk for
my clients is that along with selecting funds in different
asset classes, I select funds which diversify their strategy.
Some of the funds we hold for clients remain nearly
fully invested in their asset class, regardless of what is
happening in the market. Other funds we select specifically have the ability to go heavily into cash or to hedge
their positions in the market by employing options, short
positions, etc. Another way we diversify strategy within
the portfolio is to hold part of the portfolio in index
funds and part of the portfolio in managed funds. There
are times when it is difficult for even the best portfolio
managers to beat the indexes, and there are times when
even poor portfolio managers beat the indexes. Holding
both types of funds also allows us to more easily move
the portfolio to a less exposed position by selling out the
index funds when the market is very weak, while not
overtrading the managed funds. Many index funds are
structured for unlimited trading while all of us are aware
of the limits on frequently trading managed funds.
The second part of this is to make sure that you share
with your clients the methods you are using to limit risk in
their portfolios. I do this when the client first comes on
with me and then additionally each year. I hold a client
event each year where I review the market and talk about
the risk managing techniques we use to help manage their
portfolios.
Ways to adapt
Consider products which have some floor (example,
annuities with a guaranteed retirement benefit). I believe
the reason that the current generation of annuity products
is so popular is the insurance companies have found a way
to cover some of the downside risk by adding optional risk
control elements. These elements range from a guaranteed
retirement payout benefit to accumulation floors.
Utilize more assets in your asset allocations which
are uncorrelated. For clients who are wealthy and have a
low tolerance for losses, utilizing uncorrelated assets such
as hedge funds or real estate may smooth their portfolio
returns.
Use dollar cost averaging. By using dollar cost averaging, your client will be buying more shares when the
price is lower and fewer shares when the price is high.
Utilize managers who have strategies which are diversified from traditional buy and hold strategies. Whether you
use mutual funds, institutional money managers or annuity
products, diversify the underlying strategies in the portfolio in order to smooth the portfolio’s performance.
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How You Can Help Irrational Investors
Make Rational Decisions (continued)
Let’s look at another emotional bias: regret. We are all
subject to the impact regret has on our portfolio decisions.
The father of modern portfolio theory, Markowitz, was
asked how he allocated his personal investment portfolio.
He said that he had 50% in stocks and 50% in bonds.
When the interviewer asked why, he said it didn’t have to
do with portfolio theory, rather he did it that way to minimize regret. An interesting facet of regret is researchers
have found people feel more regret as a result of mistakes
of comission than mistakes of omission. In other words, if
I do something and it is wrong, I feel greater regret than if
I did nothing and doing nothing turned out to be wrong.
Another name for this is status quo bias. That is why
Ken and Tina were commented that they were afraid that
as soon as they sold mutual fund B that it would go up
in price. That is another reason why we see 401(k) plan
participants in the same asset allocation as when they
originally signed up. But status quo bias doesn’t affect
just our clients, it affects us as well. Are we hesitant to
recommend to a client that they sell out a position that we
believe will underperform in the future?
Put financial behaviors on automatic pilot. One of the
new ideas in retirement planning is to have the person
decide today to make a change in the future. For example,
decide today to increase their deferral in their retirement
plan by 1% every time they receive a pay raise, and sign
the paperwork today to make that happen. Then the
increase will come into play automatically.
Use mutual funds with target dates. One of the innovations in mutual funds is the creation of funds which have
specific target dates. This allows the portfolio manager
to revise the portfolio without the client having to do
anything so that their asset allocation stays in tune with a
specified maturity date.
Another emotional bias which can do much damage
is called familiarity bias or home bias. People feel more
comfortable investing in something they know. Enron
employees owning Enron stock is a good example of
what can go wrong as a result of familiarity bias. We can
see familiarity bias in many things; people in New Jersey
investing in New Jersey companies, people who work in
technology having too high a percentage of their portfolio
in technology stocks, realtors having most of their investments in local real estate.
We, too, fall prey to familiarity bias. We might find
ourselves always suggesting the same fund family, even
when its performance might be lagging, or the same insurance company product, even when there might be others
that might offer more value. This bias also can be seen
in the way we work with clients. Do we use outdated
methods of contacting and updating clients because we are
comfortable with them?
Ways to moderate
Set sell criteria at the time that an investment is purchased.
I have found that it is a good idea to discuss with clients what
would make them want to sell an investment at the time we
are considering purchasing it. First of all, it helps manage
the client’s expectations as they voice what would disappoint
them. Second, it allows us to establish a dispassionate plan to
sell which can be implemented at a time when their emotions
may play too great a role in the decision.
Use different terminology. Instead of suggesting
someone sell an investment, suggest they exchange the
investment for another one that you recommend.
Way to moderate
Educating your clients on this concept should go a long way
to helping them eliminate familiarity bias in their portfolio.
Use MDRT or a study group to help you identify your
own familiarity bias.Sometimes it is easier for someone
else to see our practice with unbiased eyes. MDRT offers
a perfect environment of other top quality professionals
who can help you look at your products and methods and
perhaps identify things you don’t readily see.
Ways to adapt
Use discretionary trading and managed accounts.
Clients who are reluctant to make portfolio decisions
because of regret or status quo bias could be put in accounts
where the portfolio manager has discretionary authority.
This will take the sell decision out of their hands.
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How You Can Help Irrational Investors
Make Rational Decisions (continued)
Ways to adapt
period of time is one way that makes it difficult for a client
to anchor to a certain price.
Substitute another anchor or tie it to another decision.
If a client insists on anchoring, instead of using their cost
basis, try substituting a value for moving at least part of
the position. Or suggest that they sell two positions at the
same time, one that has a large gain and the one that has
the large loss, in order to have the loss benefit by eliminating or minimizing the tax on the gain.
Another cognitive bias is selective memory. Have you
ever heard someone talk about all the great investments
they have made over the years? Frequently they will have
forgotten the poor ones. Other clients will only be able to
focus on the one that lost them money. Selective memory
can mean that someone weights too heavily an event that
happened recently or it can mean they weight too heavily
an event that happened in the past. Either way, it can
greatly impact the client’s view.
Treat all assets as part of the portfolio. Even if you
don’t handle a client’s stock options or 401(k) plan investments, including those holdings in your portfolio design is
important. If they are too heavy in an asset class, you can
adapt the remainder of their portfolio to make up for that
holding. I live in an area of the country that has many
retired military people. They each have a guaranteed
retirement payment. I include a discounted value estimate
of that payment in designing an asset allocation because
that fixed payment, with COLAs is much the same as
having a large investment in CDs or bonds.
Use familiarity bias to help make good decisions.
People may have a familiarity bias for a certain family
of mutual funds or a specific company product. If it is a
good investment, you may be able to have them shift one
familiarity for another. You may be able to suggest that
they exchange their company stock holding for some of
the familiar, good quality mutual fund.
One cognitive bias I see a lot in clients is anchoring.
The example with Ken and Tina was their wanting to hold
the investment until they broke even. Another name for
this is ‘break-even-itis’.
Ways to moderate
Remind the client of times that were different. We
can help clients see their selective memory by reminding
them of experiences they had which were different than
the one they are focusing on. For long term clients, that
may be easier, but a good fact-find which asks about their
prior investment experiences, both good and bad, should
also help.
Keep a balanced perspective in our presentations.
Don’t just focus on a recent success or a huge out-performance. Make sure that you continue to manage client
expectations. When we have large gains, I tell clients that
only ¾ of that gain is theirs. They shouldn’t get attached
to the other quarter of the gain because it will go back in
the future. Expect it. Don’t be upset when it happens.
Way to moderate
Focus on potential for growth in the next year. We
advisors don’t do ourselves any favors by focusing on past
performance. It doesn’t really matter what a mutual fund
did last year if you didn’t own it. What matters is what it is
going to do next year if you do. Too often we select funds
or clients select funds based on most recent history. If the
economy doesn’t change, that may work all right. But a
manager may have done well because the asset class of his
fund was doing well. We need to think ahead and help our
clients think ahead and focus on what investments may do
best in the future environment. Yes, this is much harder.
Ways to adapt
Be diligent in your suitability paperwork and document your client’s selective memory and your efforts to
guide them. Sometimes clients insist on an asset allocation or investment which seems too conservative or too
aggressive.
Way to adapt
Use dollar cost averaging. Any way which makes it
difficult to focus on a specific historical price is good to
help eliminate anchoring. Having many purchases over a
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Make Rational Decisions
Offset the imbalance with another investment. If a
client holds an imbalance somewhere, too much real estate
or too aggressive an investment, suggest an offsetting
investment which has a low correlation. For example, if
your client has a lot of rental real estate and their selective memory from the last 5 years has them thinking that
real estate will always go up and make them money, then
consider recommending securities which do well in an
economic environment where real estate typically does
not do well. Since real estate usually suffers when interest
rates go up, you might recommend a rising interest rate
mutual fund for part of their portfolio.
Another cognitive bias is house money. Scholars
have found that people tend to take on more risk when
they have just made a large gain or when they have just
received a windfall. A good example of this is lottery
winners who end up broke. But we see this in everyday
practice. The example of Ken and Tina’s inheritance
account shows how a client might segregate some money
and throw rational methods out the door. Look for this in
clients who are holding highly appreciated stock options,
or clients who have windfall profits from real estate sales
or inheritance.
This doesn’t mean they won’t do it anyway, but I have
rarely had a client go forward with an investment where I
have put in writing that I feel it is unsuitable for them.
Ways to adapt
Set up a separate account for part of the money and let
them do what they want, but plan on it disappearing.
Tell them they will need to find another advisor.
Sometimes we have to recognize that if our clients won’t
take our advice, they should seek a new advisor. If you do
this, be sure you are ready to let go of the client. Many
times, taking such a strong stand will wake them up and
they will begin to approach their portfolio more rationally.
Behavioral finance is in its infancy. Some of the key
researchers in this area are Richard Thaler, Shefrin and
Statman and Bazerman and Gilovich. Here are some
publications which you may enjoy:
• Beyond Greed and Fear: Understanding Behavioral
Finance and the Psychology of Investing by Hersh
Shefrin
• Advances in Behavioral Finance, Volume II (The
Roundtable Series in Behavioral Economics) by Richard
H. Thaler
• The Winner's Curse by Richard H. Thaler
• Judgment under Uncertainty : Heuristics and Biases by
Daniel Kahneman
• Choices, Values, and Frames by Daniel Kahneman
• Why Smart People Make Big Money Mistakes And
How To Correct Them: Lessons From The New
Science Of Behavioral Economics by Gary Belsky
Another excellent source of practical articles on this
subject is the FPA Journal. You can get access to their
articles by going to www.fpanet.org
Ways to moderate
Include the money in the portfolio plan and allocation.
By including the money in a well thought out portfolio
plan, divergence into unsuitable investments should stick
out like a sore thumb.
Prepare a letter for their signature which specifies
that you think an investment they are making is not
suitable and that you have made them aware of the risky
consequences.
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