The Certainty of Uncertainty
Gaining a competitive edge using behavioral advice
One of Doug Lennick’s and Chuck Wachendorfer’s favorite sayings is: “investments work, but investors don’t.” Doug and Chuck, experts in the behavioral finance field, say investors tend to work less well than even their own investments because they misbehave. Doug and Chuck are CEO and President of Distribution, respectively, of Think2Perform, a company that helps individuals and organizations create sustained optimal performance. Currently consulting with and helping advisors introduce clients to the concept of investing while managing emotion, Doug and Chuck will share their insights in Competitive Edge from time to time. This is our introduction to both the concept and the duo.
Chuck: A lot has been written about behavioral finance for a long time. What is it and why is it important now?
Doug: Behavioral finance deals with the psychology of money: It is an acknowledgement that human behavior is the biggest factor in the performance of investors. Behavioral financial advice integrates traditional financial planning concepts, which are necessary but not sufficient, and combines them with the psychology of money and neuroscience.
The brain is actually wired to avoid danger and pursue opportunity When something happens outside yourself, you are stimulated emotionally first and it activates your emotional intelligence. Emotional intelligence is real intelligence, but it’s not cognitive. For example, when we get excited about something, our opportunity system is turned on; when we get frightened, our danger system is turned on—both disable our ability to think clearly and therefore we will sometimes make irrational decisions. This happens to some of the smartest people in the world. So we have to be conscious of it, and advisors have to help their clients be conscious of it so that they don’t make irrational decisions when investing.
Behavioral financial advice is relevant today, as increasingly people are becoming aware that there is this gap between investor and investment performance. And now, in a world of social media, where everyone gets to see what’s really going on, some of the problems that exist in the industry have been exposed, revealing the necessity of behavioral finance.
Chuck: When you say industry problems, what exactly do you mean?
Doug: Something that is unfortunately true of the financial services industry is that it has historically sold what is emotionally easy to get the consumer to buy, whether it’s an insurance product or an investment product or what have you. This is one of the reasons why there’s such a gap in our country between the wealthy and the not-so-wealthy. The industry takes advantage of people’s desire to have stuff and provides them high-interest credit so they can fulfill this desire, and the result is you have low-end consumers buying on credit at 20-30 percent interest rates, and they’re in debt for the rest of their lives. On the high end, the industry tends to prey on the greed and the fear of the affluent. For the investor, it is emotionally easy to buy high. Rationally we’ve been told to buy low and sell high, but emotionally we like to buy high. So the industry accommodates that, which helps explain why investments work, but investors don’t.
There’s that old song “Two Out of Three Ain’t Bad”—well that’s what’s happening here. Investors are losing because they are acting out of emotion, while the advisor and the broker-dealer still win (but not as much as they could be). What behavioral financial advice brings into the picture is the opportunity for the triple win. There is no reason why the investor, the advisor and the financial services company can't all win. Two out of three is bad when the loser is always the client.
Chuck: So the financial services industry is contributing to this problem of bad investor behavior by selling the emotionally easy buy. What are you trying to help financial advisors understand and do about it?
Doug: We're trying to help financial advisors understand that rather than getting clients to make an emotional decision, they should try to help clients make a rational decision. Irrational decision making trumps high IQ every time. It’s not about how smart someone is; it’s about how able they are to access how smart they are in the presence of competing and difficult-to-deal-with emotions. When advisors are able to get this point of rational decision-making across to clients, the clients are positioned such that whenever they need money, there's a smart place for them to get it. Instead of chasing returns they are prepared for what we call the “certainty of uncertainty.”
Chuck: Why should this matter to financial advisors?
Doug: Dalbar does a quantitative analysis of investor behavior, and in their 2014 study, they found that the 20-year return of the S&P 500 ending December 31, 2013 was 9.22 percent, while the 20-year return of equity investors in mutual funds was 5.02 percent.* That’s a gap of 420 basis points. Well, a lot of people might say they probably make it up on bonds. But it turns out that the 20-year return of Barclay's Bond Index was 5.74 percent and the 20-year return of fixed income investors was 0.71 percent.
The point is that if investors underperform the markets by that much each year, they're going to have a lot less money than they could have. Would everyone win if everyone had more money? The answer is yes! That’s the triple win.
Chuck: Does behavioral financial advice really have a significant business impact for advisors?
Doug: We've trained advisors in different venues worldwide; some of them comprehensively over multi-day sessions and followed up by ongoing coaching support. The data has been overwhelming. All the indicators, the things that all advisors want, improve when they start incorporating behavioral financial advice. There is more high-value client acquisition, better client retention, more assets from existing clients, and more assets from new clients. There is also more gross-dealer concession and more financial advice fees.
Behavioral financial advice also gives advisors a way to compete with “robo-advisors”—online advisors and do-it-yourself websites. Getting clients ready for the uncertain by helping them understand their own thinking is really what advisors must do to remain relevant in a world where they are going to compete on price with these robo-advisors. It’s the behavioral use of financial products that matters more than the quality of the product.
Chuck: It sounds like behavioral financial advice provides advisors a method of shifting away from a focus on performance when talking to clients. Is that accurate?
Doug: Yes, behavioral financial advice allows advisors to focus on the client's performance and goals instead of on investment performance. It sounds like those are the same things—client’s performance and investment performance—but they aren’t at all. Having a higher return is not really a goal. The questions should be: “What do you plan to use the money for?” and “When do you plan to use it?” The issue for most people is that there are certain life occurrences that they know will require money and for which they can plan, but there are many things for which they cannot plan.
For example, you pretty much know when your children are going to college, but you don't know when they’re going to get married. You don't know if someone in the family is going to get disabled or when family members will pass away. And increasingly, people are less and less confident that they can afford to retire, so they delay retirement.
Behavioral financial advice starts with teaching clients to make rational decisions about investing so that they have the money to reach their goals—whether planned or unplanned. When you do that, you are providing clients value; value they can’t get from a robo-advisor.
Chuck: This sounds kind of simple—I should make a rational instead of an emotional decision when investing—but is it really that easy?
Doug: It is simple, but it is not easy. Behavioral finance is about how we can help people understand that they may have a high probability of being irrational in the presence of high-energy emotions. On one end of high-energy emotions, you have petrified, scared to death; on the other end you have ecstatic, exuberant. We often use the term “irrational exuberance.” The emotion was exuberance; the behavior was irrational.
Emotional intelligence can't tell the difference between a bear market and a bear in the woods. Both bears will frighten people and often cause an irrational response, which is to run. If you run from a bear in the woods, you may lose your life; if you run from a bear market, you may lose money. So how can you be more rational in the presence of that fear? By the way, you don’t want to fight the bear either.
Warren Buffet has a saying: “The markets are the world's way of transferring wealth from the rational people to the irrational.”
Chuck: Is it possible for someone, when they're emotional, to access their cognitive thinking?
Doug: Yes. It starts with self-awareness. We have a logic chain that we think about when dealing with money and dealing with people, for that matter. It starts with this notion that effective relationships, both with money and with people, are a function of effective management of oneself, which is a function of decision making, which is a function of self-awareness. So bottom up–self-awareness equals good decision making, equals self-management, which equals a good relationship with money. The whole game begins with self-awareness.
Chuck: OK, so how can someone become more self-aware and thus begin making more rational decisions?
Doug: Think of the brain as an instrument and the mind as a musician. What’s interesting about our brain instrument is that when we play it with our musician mind, we physically change the instrument—we create new pathways in the brain, which is called neuroplasticity. Practice makes permanent. What one repeatedly thinks and does gets wired into the habit center of the brain. You can make self-awareness a habit, which is the beginning of relating effectively with money. I can practice paying attention to myself by playing what we call the freeze game.
The freeze game is the first of four “R’s”:
Recognize. Freeze, hit the pause button and ask yourself the following three questions: What am I thinking right now? Emotionally, how am I feeling right now? Physically, what am I doing right now? Just the elements of a reality check: thoughts, emotions, physical experience. The practice of that several times a day will make self-awareness happen. If I'm aware that I'm angry, excited, exuberant, etc., then I am also aware that I could be in the position to make an irrational decision.
Reflect. Once I recognize my cognitive, emotional state then I reflect on the big picture. When I reflect on my values and what I care most about, I begin to calm down. The process of reflecting and calming down forces the engagement of the cognitive brain, rather than just the emotional brain. It won’t make anyone smarter, but it will increase and improve their access to their intelligence. That’s why we say it’s not about how smart you are; it’s about how able you are to access how smart you are. That in turn allows you to move to the third “R.”
Reframe. Reframe my thinking. Framing is how I think about something and reframing is changing how I think about something. Now that I’m able to access the cognitive part of my brain, I can begin to weigh my alternatives and the advantages and disadvantages of each option. You change how you’re thinking about something in light of the values you just remembered. If you think, “I value this, therefore I should do this,” you can move to the last “R.”
Respond. I can respond. I can make a decision consistent with my goals and values. These types of decisions are more rational.
It’s important to note that on average, over time, rational decisions work better than irrational decisions. This does not mean irrational decisions never work, nor does it mean that rational decisions always work.
Chuck: Is this a new skillset for advisors?
Doug: Yes, it is new to most. They have heard of it, but based on our exposure to thousands of advisors, most haven't been able to take the concepts and apply them practically. There is a lot of theory out there, but taking it from theory to practice in your business with your clients is the difficult part. That’s the essence of what we teach advisors in behavioral financial advice.
Chuck: What should advisors do if they want to start incorporating the concepts of behavioral financial advice into their businesses and with their clients?
Doug: First, it starts with you. You can't give away that which you don't have. There is also a gap between knowing and doing. It’s really important for advisors to first embrace the concepts for themselves. If you want to begin incorporating behavioral financial advice with your clients, you should begin by practicing the four “R's” in your own life. Start with the first “R”—freeze and recognize how you’re feeling—right now. If you read this article and start practicing this the day you read it, I guarantee it will begin changing your life that day. It’s that simple.
Then practice reflecting. If you haven’t done so, you should be very clear about your own personal values, both as they apply to your life and your business, and reflect on your values on a regular basis. Use something to trigger the reflection. I use water–whenever I wash my hands, drink water or see water, I think about what’s important to me. I play the freeze game all day long and I do the value reflection all day long, because I want to be able to find my values in the dark, when I’m blinded by my brain’s natural response to a high-stress situation.
As you take this idea of behavioral finance to clients, you can explain the difference between a natural response and a rational response, and you can help them understand and practice it with the freeze game. Help them learn how to practice paying attention to themselves, and go through the values exercise with them. There are a lot of advisors who focus on values in financial planning, which is a good start, but you need to take it further. And talking about goals instead of performance is good, but more is needed. Values plus goals plus rational decisions equal results. And the focus is on helping clients get the results they need. When you combine values-based financial planning with goals-based planning and behavioral finance, you will likely end up with the best outcome for both your clients and you.
Chuck: How important is behavioral financial advice to the financial services industry?
Doug: Hugely important. The industry has an integrity problem. You don’t just hear Bernie Madoff stories, but corporate stories where, in fact, people have been taken advantage of by major companies. If people are making irrational decisions, they’re allowing these companies lacking integrity to take advantage of them. By learning how to make rational decisions, they can often head off these individuals at the pass.
*Go to www.qaib.com for Dalbar’s 2014 Quantitative Analysis of Investor Behavior.