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The Ultimate Defense Mechanism: Financial Advisors

Gayle Ronan | Dec. 04, 2013

Beyond Behavioral Finance

Much has been written about investors panicking in times of market volatility. In fact, behavioral finance experts pinpoint our instinctive biases as the primary cause in emotion-driven trading—the main culprits being our aversion to realizing losses and the comfort we find in staying with the herd.

"The very instincts that led to the survival of our species can make us pretty lousy investors."

This is why when many of us see an unexpected drop in the market, we instinctively want to sell into the panic, acting against our own best interest. But, not all of us do. For some investors, reason and the ability to maintain a long-term perspective prevail in the face of fear. Who are these people?

 

People With A Plan

The Vanguard Center for Retirement Research conducted a review of investor behavior within the 401(k) accounts its firm manages during the 2008–2009 Financial Crisis and the five years that followed.1 What Vanguard found was very little evidence of panic. The overwhelming majority of plan participants stayed the course. Even among the 40% who did trade, the majority of the portfolio changes were fairly minor. Overall, only 3% of the participants abandoned their allocation and sold all of their equities. While the study credits the long-term perspective of 401(k) investors for the lack of panic, it also highlights the beneficial role inertia may play in 401(k) decision-making.

Once participants make their initial elections and enact a long-term plan, they appear to let the plan take over. The effect of regular savings contributions may also add to the ensuing peace of mind. The monthly deposits help offset the decline in account value during sell-offs. When the participants look at their plans, the market’s impact may not seem so bad as to warrant action. In short, investor inertia—at least among plan participants—seems to offer better investing instincts that human nature.

 

Other Factors That Defend Against Panic

Researchers Chris Browning and Michael Finke find that the older, wealthier and more experienced an investor is, the less likely they are to panic in the face of volatility. The implication is that investors tend to learn from their mistakes. Panic is not necessarily a permanent reaction but one associated with youth and inexperience.

Browning and Finke also found that the higher someone’s cognitive strength, the more likely it is that their reasoning brain will overcome their emotions and stay the course. However, they have found that the elderly, despite having gained experience through many market cycles and learning to behave in a financially sound manner, may start to lose their perspective as their cognitive abilities decline late in life and as their own planning horizon shortens.2

Having someone to talk to also helps. In fact, Finke and another colleague, Sandra Huston, found what they feel is the primary driver for staying the course and maintaining a long-term perspective—working with a financial advisor and committing to a written financial plan detailing the process of long-term investing.3

 

Preempting Panic

In addition to the above factors, Finke, working with researcher Michael Guillemette, has also looked at the value of using risk tolerance questionnaires to determine their predictive use when it comes to investor panic. After all, financial advisory firms use risk tolerance surveys for this purpose, though anecdotal experience shows that clients often act in ways that are at odds with their responses to these questions. The blame for that, however, rests largely with projection bias.

Projection bias causes us to project our current view of the world into the future. An investor who is calm and feeling pretty confident about the market when answering risk tolerance questions will project that frame of mind into the future and assume that they will remain calm and rational in the face of a future market crash. When the day arrives, instinctive reactions can override the rational mind and lead to panic if no preemptive efforts to add knowledge have been made in the interim.

Beyond the role of this behavioral bias, what Guillemette and Finke found is that questions measuring loss aversion were somewhat effective in determining whether a person would panic and cash out of their holdings. They also found that a person’s mindset tended to be predictive—someone who dwells on life’s negatives, in general, was more likely to react poorly when their worst fears were realized.

But an even better predictor arose from finding out how much risk an investor had taken in the past, reinforcing the role that market experience plays in determining an investor’s reaction to market volatility.

 

How Marketing Can Help

What are the key take-aways from these recent studies into investor behavior? To marketers, they imply that we have a role to play in helping financial advisors combat behavioral biases. What can we do?

  1. Be preemptive: Arm advisors with material that helps investors stay focused on their long-term goals. Investors are better served if they understand the role a product plays in a portfolio rather than its most recent performance returns.
  2. Be educational: Greater financial literacy is associated with higher levels of investment success.
  3. Be bias aware: Behavioral biases underlie decisions and can undermine them. Offer counterarguments in anticipation of biases kicking in to arm the rational mind against the emotional.
  4. Be aspirational: While fear is a strong motivator, playing into it typically ends in the type of rash decision-making that undermines long-term goals. Helping build confidence through planning may be more productive.

 

[1] Stephen P. Utkus and Jean A. Young, "The great recession and 401(k) plan participant behavior," The Vanguard Center for Retirement Research, March 2011.
[2] Chris Browning and Michael Finke, "Did Cognitive Ability Affect the Stock Allocation Decisions of Older Investors During the Great Recession?" Working Paper, 2013.
[3] Sandra Huston and Michael Finke, "Investor Prudence and the Role of the Investment Advisor," Working Paper, July 2011.

 

Gayle Ronan

Gayle Ronan

Gayle has over 25 years of financial services marketing, research, and writing experience to craft compelling content for the digital age.