The Tool to Get Clients to Make Tough Decisions
July 15, 2014
by Dan Richards
Last week’s column outlined how monitoring ongoing progress can help achieve short-term goals, inspired by a recent New York Times article on finishing times in marathons. That article, titled What Good Marathons and Bad Investments Have in Common, addresses what behavioral economists call “the disposition effect,” academic-speak for the unwillingness of investors to sell an investment when it entails crystallizing losses, even when it would otherwise make sense to do so.
We saw this in the housing downturn, as Americans stubbornly hung on to their homes waiting for prices to get back to what they paid. And every advisor has run into this reluctance on selling stocks that are down sharply. The good news – research on an approach called “pre-commitments” sets out a path that can help you persuade clients to make a tough decision when the original rationale for making a purchase has changed and it’s time to take a loss and move on.
Warren Buffett’s take on loss aversion
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The concept that investors are averse to losses is far from new, but it was first quantified in research by psychologists Daniel Kahenman of Princeton and Amos Tversky of Stanford. Their 1979 paper “Prospect Theory: An Analysis of Decision Under Risk” is a seminal work that explores what appears to be irrational decision-making:
- Facing a 95% chance of winning $10,000, the average consumer accepts an unfavorable offer of $9,000.
- But the same consumer, facing a 95% chance of losing$10,000, rejects a favorable offer of paying $9,000.
Their conclusion: “Losses and disadvantages have greater impact on preferences than gains and advantages.” Kahneman received the 2012 Nobel Prize in economics for this work (Tversky had passed away and thus was ineligible). The reluctance to sell losing investments was further quantified in 1998 research by Terence Odean of University of California Davis who analyzed trading records of 10,000 accounts at a large discount brokerage house. His conclusion: Investors reduce returns by selling winning investments too soon and holding losing investments too long.
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