In today’s marketplace, access to information happens almost instantly. With the click of a button, you can get answers for virtually any retirement question you ask as long as you have an internet connection. Actually, now that I think about it, all you need is a smartphone!
In another time, not so long ago, people relied on other people (financial advisors) as almost the sole source of information when it came to retirement questions. Today, there are literally hundreds (if not thousands) of blogs, columns, and books that claim to have all the answers you need about any given topic in the realm of personal finance, including retirement. The challenge, however, is determining what to believe since the abundance of information has done nothing but create more voices shouting different opinions about the “right” approach to retirement income planning.
Now that we are seeing technology play a much larger role than ever before in the industry, one thing that is becoming a byproduct of this change is that the information filters (advisors) are having a more difficult time than ever managing client emotions. A recent article in the industry publication Think Advisor cited a study done by Natixis Global Asset Management where 90% of the advisors surveyed said that their top challenge over the next year was dealing with client emotions over market swings.
Why is emotion such an enemy for clients trying to reach their financial goals?
There are many different resources that speak to this topic, and I’ve picked 3 different ideas that resonate with me:
- We are wired to avoid pain and seek pleasure. We cannot escape this simple truth because it’s part of our biology. Just about every single decision we make is geared around this reality. I think most people would agree that the idea of losing money is, well, painful. Therefore, putting our hard earned money into a stock market where we have zero control over market performance is unsettling (at best) for most people. Forget logic. Forget data. Forget Strategy. If the market starts to move a little too quickly in a poor direction, people tend to panic. At this point, our emotions take over. Yet, this is precisely when we need to remember how our investments are allocated according to our goals and make decisions based on principles not our emotions.
- We put too much emphasis on recent events. This is called “the recency effect” or recency bias. This type of bias occurs when we easily recall and put more emphasis on things that have happened more recently than things that happened further in the past. For example, at the first sign of market volatility, many investors revert back to their primitive brain—the one designed to avoid pain. A couple of weeks worth of market swings is all it takes to make the average investor forget about a longer uptrend in the market. Moreover, when things are truly bleak (think 2008-2009), we tend to believe that the markets are finished. Financial author, Carl Richards puts it this way, “When we ignore history, we end up basing our actions on our own limited experience. That can be very dangerous.”¹
- We tend to plan for the average expected rate of return. This is called central tendency. Part of the investment planning process typically involves discussion about historical rates of return and projected (or hypothetical) rates of return. During this conversation, we advisors attempt to give our clients a realistic expectation of the average rate of return for a particular investment strategy. Clients almost always gravitate towards the rate of return or performance. Why? Because it feels good to think about making money (pain vs. pleasure). Unfortunately, what happens more often than not, is the client gets this average rate of return burned into their mind as the benchmark for performance in the short run. For instance, let’s consider a portfolio that has an average rate of return of 9% over the previous 5 years. As we professionals know, this number is based on historical performance. Clients begin to think that their portfolios should hit 8-10% annually; and they completely forget that this number is an average. Thus, a year that returns 3% is considered a failure, despite the portfolio may have performed well considering market conditions. This results in pain because the expectations were not met, even though the results being measured are short-term results.
There are many more examples of how our behavior affects investment decisions, and perhaps I will blog more about them in the future. I have found the field of behavioral finance and neuroeconomics to be fascinating because I see so much of the research play out in real life.
If I can tell clients or investors one thing, it’s that you MUST create a plan for yourself. I encourage everyone to engage with a financial professional—-preferably one with a CFP® designation. Don’t sell yourself short because your financial future is too important. One of the most compelling values that a qualified financial professional can bring is objectivity. Having someone who can help you develop a plan that’s centered around your goals, give you objective advice, and hold you accountable is well worth the investment.
¹Richards, Carl (2012-01-03). The Behavior Gap: Simple Ways to Stop Doing Dumb Things with Money