Manage clients’ emotions to get better returns

The watershed

There are two events that changed how I approach finance: the 2008 downturn, and a behavioural finance seminar I attended in 2009. Thinking of 2008 and its bearish impact on people’s money, I’ve come to five conclusions:

1. I’m not as smart as I think.
2. A contrarian approach is a sound way of balancing off the noise of the media. It also prevents one from being overconfident and falling victim to the recency bias.
3. If clients understand correlation, it can help them protect their downside risk, and level out their volatility swings.
4. Protecting the downside is more important than working on creating a positive upside.
5. Mutual fund companies and wholesalers exist to make money.

These deductions have helped me develop some seminal principles of my own.

The right approach

The most reliable approach to investing is:

• Stay invested for growth.
• Diversify broadly across asset classes for both growth and capital preservation.
• Maximize the benefits of compound growth through tax-efficient investing.
• Regularly rebalance proper asset class ratios to align with your level of risk.
• Broad diversification, with annual rebalancing, remains the best equity strategy to pursue your long-term financial goals. It is the antidote to panic in falling markets.

The epiphany

The seminar I attended discussed how advisors can add great value via behavioural finance. It was based on the messages of Nick Murray, a 45-year industry veteran and an early adopter of behavioural finance principles.

Some key points I learned:

• Promising better-than-average returns is a fool’s game.
• No one can predict the future; and the past is not a reliable guide.
• It’s not always about how portfolios are constructed. Emotions and cognitive biases are often the main reasons investors make costly mistakes.
• Most of the information disseminated by fund companies and the financial press can be safely ignored.

Many of the theories I grew up with—efficient market hypothesis; modern portfolio theory; and the theory that investors always choose the outcome with the greatest reward—were inherently flawed. I have realized markets and people are irrational.

Daniel Kahneman and Amos Tversky, early proponents of the Prospect Theory, have also shed light on investors’ behavioural irrationality that invokes investment decisions based on perceived gains, rather than perceived losses.

As I became more familiar with behavioural biases, and how they impact investment values, I realized I was succumbing to the same biases as my clients—overconfidence, overreaction, and recency bias (favouring newer information over older information).

To counter these biases, I now approach everything with a contrarian attitude—constantly questioning what I’m being sold or told. In my initial meeting with clients, I also share my philosophy about human behaviour being the main reason people lose wealth.

My main job is to help clients avoid mistakes based upon emotional decisions or cognitive biases. Sometimes, simply managing people’s psychology can produce significantly better returns.