Advising the Behavioral Investor: Lessons From the Real World

As a long-time student of behavioral finance, I was thrilled to be approached just over a year ago to contribute a chapter to a textbook on the subject. I now have the pleasure of seeing that contribution in print with the recent publication ofInvestor Behavior: The Psychology of Financial Planning and Investing, edited byH. Kent Baker and Victor Ricciardi.

Over the course of 30 chapters, the book discusses the major principles of investor psychology and behavior as it relates to trading, managing their portfolios, and financial planning. My chapter, “Advising the Behavioral Investor: Lessons From the Real World,” draws from Gerstein Fisher’s 20+ years of practical experience working with individual investors to bring some common behavioral finance theories to life.

The Only Thing to Fear…

I frequently give a nod to Franklin Delano Roosevelt’s famous proclamation that “The only thing we have to fear is fear itself.” Empirical research points to the fact that Roosevelt’s proclamation during the depths of the Great Depression absolutely applies to investing nine decades later—when unchecked, investors’ emotions can wreak havoc on even the most well conceived investment strategy.

Take market timing. Research demonstrates that people have a tendency to chase returns; to overinvest money in sectors and asset classes that have exhibited strong recent performance in the hopes that that performance will persist into the future. The dot-com bubble is a prime example: in the late 1990s and early 2000s, investors poured approximately $18 billion of new assets into domestic equity funds, with inflows continuing right up until the bubble burst, wiping out trillions of dollars in market value over the ensuing two years. Less than 10 years later, investors proved they hadn’t learned their lesson when real estate and securitized real estate assets underwent a similar cycle, with even more damaging results.

Similarly, risk aversion tends to rise when perceived risk increases. This makes intuitive sense from a behavioral standpoint, but in investing, risk and return are related—it is precisely sources of risk that drive returns. Too often, however, investors’ fears drive them out of the market at precisely the time of greatest opportunity. They park money on the sidelines when they can no longer stomach a protracted down market, only to miss out on the upturn when it eventually happens. Consider the poor investor who bailed out of the market in 2008 or early 2009, only to miss the phenomenal gains of the past five years. I’ve always felt that one of the greatest services we provide to our clients is by helping them stay disciplined in the face of truly frightening market corrections.

The Role of the Advisor

In writing about all of this, my core assertion is that there is a  vital role for financial advisors to play by serving as a kind of buffer between investors and their portfolios.  I have always felt that one of the greatest services that advisors provide to their clients is by helping them stay disciplined in the face of truly frightening market corrections.

From discussing investment risk to better understand the clients’ near-and long-term objectives and tolerance for volatility to “talking them down” from making emotion-fueled, short-term decisions that might derail their long-term strategy, advisors can be a critical aid to investors in managing their behaviorally driven investing and mitigating financial mistakes.

We have, in fact, quantified the loss to investor behavior and the value-added of an advisor through our research (we come up with 1-3 points per year) at Gerstein Fisher and the Gerstein Fisher Research Center. Investors and advisors will be interested in a published paper from our Research Center:

I also encourage you to read our paper Past Performance Is Indicative of Future Beliefs, in which my co-author Phil Maymin and I used Morningstar data to examine the average investor’s actual return in mutual funds from January 1996 to December 2010. We have updated this research in a somewhat similar study in In Mutual Funds, is Active vs. Passive the Right Question?. Finally, I have discussed the important topic of how advisors can help the behavioral investor in a short video: