Financial Physicians: Behavioral Finance Insights for Financial Advisors, Study notes of Finance

Download Financial Physicians: Behavioral Finance Insights for Financial Advisors and more Study notes Finance in PDF only on Docsity! Financial Physicians The findings and insights of behavioral finance can be useful to financial advisors. As an educator, I often speak with financial advisors. "Imagine that you are meeting with an investor," I say, "tell me what frustrates you most about the client's expectations." Advisors’ answers are not surprising: Investors want the highest returns, with no risk, no taxes, and no fees, and the really rich investors want even more. What can advisors offer? They can offer potentially greater wealth, improved well-being and a good balance between the two. Several years ago, I attended a meeting between a financial advisor and a potential client, a well-educated man who had just received more than $30 million from the sale of his father's business. His brothers and sisters had each received the same amount. The advisor was trying to help the man build a well-diversified portfolio com- posed of domestic and international stocks and bondsa balanced portfolio with low risk that would deliver good returns over the long run. But the man was distressed. Confident they could pick winning stocks, his brothers and sisters had chosen concentrated portfolios. They ridiculed his ideas about well-diversified portfolios and were sure to laugh at him when they came out ahead. As I listened, I realized I was happier than this much wealthier man. I had much less wealth but much greater well-being. Wealth and well-being what makes people happy, what investors want, and what advisors can offerthese are the themes of my presentation. The Financial Physician Many investors want more than a balance of risk and return or more than simply enough money for a secure retirement and college education for the children. Many investors want to: be "number one," to win the race, and to outperform neighbors or siblingsa11 of which cause stress. The man I just described was miserable even while holding $30 million. Success in investing is about status; it is about security; it is about life. Financial advisors must be financial physicians. To the knowledge of markets, securities, and portfoliosall the lessons learned from the science of financefinancial advisors must add the qualities of good physicians: listening, hand-holding, and reassuring. Physicians promote health and well-being, and financial advisors promote wealth and well-being. Listening. What are investors' aspirations, emotions, and thoughts? What do investors really want? Like a good physician, an advisor must really listen to whit investors need and want; Suppose a client took to heart a comment made by his brother-in-law at the last family gathering that implied his brother-in-law was wealthier, and the comment still bores into him, even two weeks after it was made. This client does not want to discuss his angst about that comment with anyonewhether an old friend or a new investment advisor. So, how can an advisor uncover this client's true feelings? The answer is through listening, empathizing, and diagnosing, just as a physician does. Investors trust good advisors as they trust good physicians. And trusting investors are honest investors. What do investors really fear? Is it risk? Is risk standard deviation? Much too often advisors jump into questionnaires about risk tolerance and miss the real fears and aspirations of investors. Consider international diversification. Risk is not what is driving investors away from international diversification; nor is an increase in correlations between domestic and foreign stock returns. Investors are being driven away from foreign stocks by the miserable performance of such stocks in the past decade and the feel that more miserable performance is in store. Financial advisors should think of themselvesand present themselvesas financial physicians. Investors bring to financial advisors their stresses, fears, aspirations, and biases. Advisors can help investors balance wealth and well-being by using tools of wise physicians: asking, listening, diagnosing, educating, and treating. Docsity.com Stress and Status. Good investment advisors listen to clients to uncover their sources of stress. A recent book contains interesting articles about well- being, including a particularly intriguing article by Robert Sapolsky that compares the physiology of animals under stress with that of humans under stress. Consider two humans sitting at a chessboard and moving pawns from square to square. Their heart rates and hormone secretions respond as though they are gazelles being chased by lions. What is going on? Gazelles experience hormone secretions that increase their heart rates only when under stressthe fight-or-flight phenomenon, but we humans tend to be under stress all the time. We worry about mortgages, relationships, and the thinning ozone layer, all of which are mysteries to the gazelle. This constant stress can cause actual physical ailments, such as heart disease. We experience stress most often in environments of little predictability, little control, and little social support. The man I described earlier who was given more than $30 million had only one reasonable optionto invest the money. He was thus facing the unpredictability of securities markets for many years to come. Securities markets are an environment in which we have little control and a place where we find little social support. Indeed, in the world of investing, friends and relatives are more likely to be competing against than supporting one another. (Interestingly, studies on behavior show that brothers-in-law are a source of particularly great competition and stress.) What reduces stress? Status reduces stress. We always compare ourselves with others. Are we richer than our brother-in-law? We also compare our current positions with our own past positions and our aspirations for the future. Are we richer today than a year ago? Are we as rich as we aspire to be? We are happy when our status is high relative to that of other people and to our own past, or aspired, positions. Wealth is absolute. Status is relative. Although most people cannot imagine what it would be like to be worth $100 million, most can easily imagine what it would be like to earn an extra $100,000 a year. This fantasy might become an aspiration and that aspiration brings with it the stress of knowing that "I am not there yet." Status seeking is good for us as a society because it spurs economic growth and innovation. But status seeking is also bad for us individually because it spurs stress as it separates winners from losers. Moreover, status is not fixed. Declines in relative wealth can be rapid, and status can drop even if wealth does not. An entrepreneur who brought her company public and netted $50 million is happy until she discovers that her rival netted $100 million. I remember an old story my mother told me about a man who complains to his rabbi that his house is much too small for him, his wife, and their many children. "Bring the goat inside the house," instructs the rabbi. The instruction makes no sense, but the rabbi is the rabbi. A week later, the man returns to the rabbi to complain that now the situation is intolerable. "Take the goat out of the house," instructs the rabbi. Suddenly, the house feels big. Reasonable Benchmarks. The story of the man, the rabbi, and the goat is valuable to advisors because it addresses the concept of benchmarks. Advisors have to adjust the benchmarks, or aspirations, of their clients {and themselves). Whenever a client says, "Gee, I am not doing as well as Joe; Joe told me he invested in XYZ stock, and he has done so well," the advisor needs to change the benchmark of that client so that she can see how far she has come in her own investing. Remember that status and well- being can depend on one's position relative to other people as well as to one's own past and aspirations. Benchmarks and aspirations need to be reason- able or stress will inevitably rise. My wife and I just finished renovating our home, a giant project. The other day, I realized that our new kitchen is bigger than the entire apartment we had as students. That apartment serves as a perfect benchmark. I say, "Relax some, Meir, you are doing okay." Lessons of Behavioral Finance. Why do we humans behave the way we do? The answer is that the forces of evolution have designed us to behave this way. Our brains have evolved as our other organs have. The brain evolved to have modules that perform special tasks, just as the heart evolved to pump blood. For example, an important task of the brain is rapid recognition of facial expressions, knowing whether someone is happy, sad, angry, or threatening. This capability is hardwired because of its importance for human survival and reproduction. The same is true for status seeking. But not every- thing that is hardwired or "natural" is useful. Our brains do not develop as fast as our environment, and modules that helped us in past environments can hurt us in today's environment. Status seeking is crucial Docsity.com the wrong lesson in the stock market, where randomness and luck rule. We feel regret because we chose a stock that proceeded to crash when, in fact, we were simply unlucky. Regret is associated with responsibility. Investors in the throes of regret often try to soothe the pain of regret by shifting responsibility to the nearest person. Often, this person is the advisor. "I didn't choose foreign stocks," say investors after foreign stocks post miserable returns, "My advisor chose them for me." ♦ Self-control. The ability to learn self-control, like the ability to learn a language, is hardwired. But unlike language, self-control must be taught. Children may not be as eager to embrace self-control as they are to learn a language, but self-control has to be taught by parents because the ability to postpone pleasure is crucial for life. Advisors must extend the self-control lessons of parents. Self-control is especially challenging for young or new investors, such as actors or athletes; who receive huge amounts of money at young ages. Investment advisors sometimes resort to drastic solutions, such as doling out an allowance to the client while keeping the bulk of the money under their control. And lest one think self-control problems affect only young wealthy people, think about the rest of us. Social security, 401(k) plans, and IRAsany pool of money that cannot be touched without penalty until some advanced ageare mechanisms to help us control the urge to spend. But there is such a thing as too much self-control. Some clients need to be persuaded to spend more. Some people in their 70s and 80s insist on saving and feel financially insecure despite their $30 million portfolios. Advisors can help such clients relax the purse strings a little; a cruise around the world, for example, would not break the bank. Wealth and Well-Being among the Very Wealthy. Some events in life bring a person both greater wealth and greater well-being. For example, Panel A of Figure 1 shows the efficient frontier for an entrepreneur who just brought her company to market m an IPO. She has moved up the wealth axis and the well-being axis. She now has a greater amount of money and a greater sense of pride and achievement. Once the wealthy (and the rest of us) are on the efficient frontier between wealth and "well-being, however, they face trade-offs. They can have more well-being, but only if they deplete their wealth. Admiration enhances the well-being of the wealthy, but the wealthy we admire are the ones who contribute wealth to worthy causes. People admire Rockefeller and Carnegie for establishing the Rockefeller and Carnegie Foundations, not for making lots of money from oil or steel. As shown in Panel B of Figure 1, the wealthy can trade off wealth for well-being. When they donate their money to promote health in Africa or to support their alma mater, they lose wealth but gain well-being. Not all wealthy people understand the trade-off between wealth and well-being, and not all accept that society does not owe them admiration, or even respect, just because they are wealthy. One potential outcome is the "angry affluents" phenomenon, where people conclude that ''as rich as I am, I am not rich enough." Some angry affluents have been stung by insurance schemes or phony trusts set up to avoid taxes. The outcome of such schemes is rarely positiveeither from a wealth or a well-being standpoint. Financial advisors can point out to angry affluents that they can reduce both their anger and their taxes by donating money to a cause they really want to support. They will lose some wealth but will gain well-being. Some wealthy worry that they are not wealthy enough, but others worry that wealth takes a toll on themselves and their children. Parents who used to worry about not being able to pay for their children's college education instead worry about their children turning into spoiled brats. Again, financial advisors can help investors and their children see the benefits of balancing wealth with well- being and can create structures, such as family charitable foundations, that facilitate that balance. Conclusion Conversations with clients often resemble the Gary Larson cartoon in which the man says to his dog, "Ginger, I have had it! Stay out of the garbage, Ginger. Understand, Ginger? Stay out of the garbage, or else!" And Ginger hears: "Blah blah blah, Ginger. Blah blah blah, Ginger. Blah blah blah, Ginger." Financial advisors say, "High returns cannot be guaranteed. No one can guarantee that high risk will Docsity.com bring high returns. No guarantee, you understand?" And clients hear: "Blah blah blah high returns. Blah blah blah no risk. Blah blah blah guaranteed!" Conversations with clients can be frustrating. Remember that investing is about more than money. It is about reducing stress in an environmentthe securities marketsthat creates large amounts of stress. Advisors need to remember the story of the man, the rabbi, and the goat to maintain their perspective. Follow the pattern of the physician: Ask, listen, diagnose, educate, and treat. Financial advisors who act as financial physicians combine the science of finance and securities with the ability to empathize with and guide clients-thinking not about risk and return but about investors' fears, aspirations, and the errors they are likely to make. Financial advisors promote wealth and well-being just as physicians promote health and well-being. Life does not resemble the Olympic games, and there are better goals than being first at the finish line. Remind clients, "Who cares if your brother or sister has $31 million and you have only $30 million? You have more than you could possibly need for anything you might reasonably desire. If your desire to outrun your siblings is so strong that it causes you to collapse midway through the marathon called life, what good is $31 million? The real goal is to get to the finish line in one piece.” Docsity.com Figure 1. Wealth and Well-Being Efficient Frontier A. Day of the IPO B. Later, after Donating Money to a Charity Well-Being Well-Being Wealth Docsity.com