The key to better returns

Here are some surprising facts:

• The S&P 500 Index had an annualized return of 9.14% for the period ending December 31, 2010.
• The average equity investor only made 3.83%, ignoring taxes and inflation, in the same time period.

Recently, a school of thought has emerged called behavioural finance. The key point of this discipline is that the decisions people make are influenced just as much—if not more so—by psychological and emotional factors as by logic.

Psychological and emotional factors lead people to buy high and sell low. They react to the latest news and make ill-timed changes in their portfolios. They make important investment decisions based on limited information, facts and research—on yesterday’s news.

If we understand these factors and how these bad behaviours affect performance, we can help our clients manage their behaviour and achieve better financial results.

Some of the bad behaviours

In 1979, psychologists Daniel Kahneman and Amos Tversky introduced prospect theory, a radical new way of understanding how humans make decisions under stress.

People value gains and losses differently, basing decisions on perceived gains rather than perceived losses. A loss has much more of an emotional impact than the joy of a gain.

In fact, some studies suggest the pain of a loss is twice as great as the joy from a win. This is known as loss aversion. As a result, people sell winners quickly to consolidate the gain and hold on to losers too long because they don’t want to realize the pain of the loss.

Logic tells us to let the winners run and sell the losers, but logic is only part of the equation. Perception is reality, an adage at the heart of another characteristic called confirmation bias. In life, first impressions rule and are hard to overcome.

We look for information or ideas that confirm our preconceptions about an investment rather than for information that might contradict it.

Another bias investors have is overconfidence. Overconfident investors tend to be more active traders, presenting another problem. They believe they are better at choosing when to enter and exit a fund or markets. They must make two good decisions – when to buy and when to sell.

Herd mentality

Humans want to follow the crowd. This tendency can be deadly in investing. Average investors don’t research, read, or educate themselves so they often make decisions with limited information and follow the crowd right over the cliff.

We all want to be liked and in investing it is easier to promote a viewpoint that is consistent with the group consensus than to offer a contrarian one. After all, a large group can’t be wrong, can it?

Over a market cycle, emotions get in the way of logic. Traditional advisor training doesn’t equip us to deal with the emotional side of decision-making. We have been taught modern portfolio theory and the effficient market hypothesis. We learned things like alpha, beta, and standard deviation, and used them to build portfolios for our clients. The counsel we can offer, then, is logical but flawed.

We are thinking and advising with our left brain only. The emotional right-brained side of people is especially dominant in times of economic uncertainty. People’s emotions are triggered and they revert to defensive behaviours because they feel threatened. By offering advice using our left brain when our client is in right-brain mode, we create tension in the advisor-client relationship.

Also, emotions, attitudes and beliefs can be the key drivers of decisions. How can we get our clients to open up about their feelings if we approach things from a left-brain perspective?

We often ask too many factual questions, such as type of assets, amount, and where are they invested.

These are important, but open-ended questions will uncover feelings and attitudes. For example: How do you feel about the recent market volatility?

Does overconfidence impact advisors? Studies have shown people are overconfident in many aspects of life, from driving a car, to their IQ, to their ability at hockey, baseball or any other sport.

Overconfident advisors tend to focus on their successes but often repress failures. One example is when advisors try to time the market, overconfident in their timing and selection skills. They may have contributed to the low returns noted at the beginning of this article. Being aware is part of the solution.