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Help clients take the emotion out of investing

par Rosemary McCracken | April 22 2014 07:19PM

Money, especially the idea of losing it, is a major trigger of high emotions. “People tend to get emotional about their money,” noted Gaetan Ruest, Investors Group’s vice president, corporate research, in Winnipeg.When times are good, human beings tend to use their reason, said Lisa Kramer, associate professor of finance at the Rotman School of Management at the University of Toronto. “In times of crisis, we tend to revert to our caveman instinct to run from the sabre-toothed tiger.”

This instinct can cause investors to pull out or stop investing when markets are down. And it can be a serious obstacle to financial advisors in helping clients to achieve their financial goals. “Investors who sell when the market is 30% down, as it was in 2008, will have no hope of recovery,” said Dean Askwith, a financial planner with BMO Financial Group in Saskatoon.

Greed and fear

Greed and fear are emotions that can have the greatest negative influence investment decisions. Greed can drive investors into get-rich-quick schemes, “especially if they don’t understand the relationship between risk and return – that, in general, the higher the investment risk, the higher the potential for return. Low-risk investments, such as guaranteed investment certificates, may not keep pace with inflation,” Mr. Ruest said.

Many investment markets did extremely well last year, noted Philip Bensen, senior vice president and head of national sales/Canada at Franklin Templeton Investments Corp. in Toronto. “So more people may now be willing to take on more risk.”

And the tendency of human beings to follow the herd can add fuel to greed. “We don’t live in vacuums so we listen to and are influenced by our families and friends,” Mr. Bensen said, citing the example of the dot.com bubble of almost 15 years ago when a wave of investors speculated on information technology firms without looking at the companies’ fundamentals.

“Right not, we’re seeing investors who want to get in on the ground floor of bitcoin [the digital currency system],” Ms. Kramer noted.

But fearful clients are much more common than greedy ones. “Most of us are strongly averse to losing money,” Mr. Ruest said. “Investors are much more willing to avoid a loss than to explore a gain. They’re more comfortable protecting their capital than pursuing long-term returns.”

Fear of losing money is common throughout all age groups, but he said that people feel most vulnerable to loss when they have few sources of income. “For a retired person,” he said, “the idea of losing assets translates into losing part of his salary.”

“Clients who receive regular employment income are less likely to react emotionally to market fluctuations,” added Scott Gerlitz, financial advisor with Edward Jones in Calgary. “It’s in the pre-retirement and the retirement years that emotions tend to increase exponentially. Clients realize they have finite amounts of assets to see them through the rest of their lives. A CEG Worldwide survey of U.S. investors found a whopping 85% of advisors are fired by clients who are approaching retirement because people are extremely emotional about their finances at this time.”

Advisors can take the emotion out of investing for clients simply by designing portfolios that are tailored to clients’ specific situations, Mr. Ruest said. “Once the appropriate target portfolio has been established, the advisor needs to remind the client that its value will be subject to volatility. Unless the client’s circumstances and requirements have changed, the portfolio should remain the same.”

Nebulous concept

Advisors should have their clients address the idea of negative returns before they actually see them. “The advisor needs to translate the nebulous concept of risk into dollars,” Ms. Kramer said, by asking, “ ‘How would you feel if your portfolio lost $100,000?’ Have the client confront that emotion now, before a crisis occurs.”

“When the value of the portfolio drops it will be very difficult to convince clients that temporary negative returns are a natural part of the investment process,” Mr. Ruest added. “It has to be discussed beforehand. In some ways, it’s similar to coming up with a plan to follow in case of a fire. ‘If a fire breaks out, we know exactly what we’ll do.’ ”

Clients who still react negatively, he added, probably have lower risk tolerance than they said they had. “Changes may need to be made to the portfolio to accommodate this.”

And if the advisor discovers that an investment holds a higher level of risk than he initially believed it did, he may have to make changes to the portfolio, Mr. Ruest added. “But this shouldn’t be a knee-jerk reaction but rather a rational decision.”

Reliable income

Mr. Gerlitz said that ensuring that clients’ portfolios behave like pensions takes the emotion out of investing for pre-retirement and retired clients. “We need to structure portfolios to produce three to five years’ worth of highly reliable income. When the client’s income doesn’t fluctuate, he’ll let the investment portfolio do what it was designed to do.”

Edward Jones, he added, has two rules in place to safeguard client portfolios. “We don’t want clients to have more than 5% of their portfolios’ assets invested in one stock,” he said. “And we invest for the long term. Asset allocation is responsible for 91% of a portfolio’s returns, hanging in there is key.”

Ms. Kramer noted that fear can be a temporary emotional state, rather than a personality trait, and that advisors need to recognize that there may be periods when clients are more risk averse than others. “My research shows that people tend to be risk averse in the fall and winter for the same reasons that some suffer depression or season affective disorders – lack of light. And depressed people also tend to be more fearful,” she said. “A client who fills out the know-your-client form in the fall or winter may indicate that he is more risk-averse than if he filled out the same form in the spring or summer.”

Clients who are driven by fear probably don’t have a good understanding of the basics of investing, Mr. Askwith added. “I always look for ways in which I can make my clients more financially literate.”

Mr. Ruest added that advisors themselves can also be crippled by fear, especially advisors who have an overwhelming desire to protect their clients. “They need to focus on a long-term approach to achieve their client’s goals. Investors are looking to them to provide the appropriate investment process.”

Investors are looking to their advisors for emotional reassurance, Mr. Gerlitz added. “When there is turbulence on an airplane, we automatically look at the stewardess. If she’s calm, we relax. If we see her clutching the seats, we start to worry. And clients will look to their advisors in the same way in times of emotional turbulence.”

“In short-term down markets, I reach out to as many clients as I can,” Mr. Askwith said. “In prolonged down markets, I reach out to everyone.”

The four types of emotional investors

Financial advisors need to become amateur psychologists, attuned to different investment behaviours. Gaetan Ruest, Investors Group’s vice president, corporate research, in Winnipeg, cited four types of emotional investors that advisors should watch for:

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  • Clients who are overly concerned about investment losses, but not the loss of purchase power over time. “Most people think in terms of present dollars, not in future dollars.”
  • Bandwagon-jumping. “Some clients tend to be influenced by articles that tell them they should have a lot of exposure to gold, or that tech stocks are a good buy. They may want to modify their portfolios on a daily basis.”
  • Clients who have strong reactions to negative news. “The worst time to sell is after a decline in value, and growth investments will have a higher volatility. Unless the client has an immediate need to sell, he will have to look at volatility as a natural part of the investment cycle. Temporary negative returns are part of the investment cycle.”
  • Clients who want to allocate new money to a sector of the portfolio that has done well. “They need to take the opposite approach and use the new money to rebalance back to the target portfolio, which means directing the new money to the sectors, and perhaps even the individual securities, that have not done well. The short-term performance of individual components of the portfolio should not influence the allocation of new money.”
  • The upside, Mr. Ruest added, is that these behaviour types are not so ingrained that they can’t be changed.

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