How to deal with irrational clients
Advisers who assume their clients will behave rationally when investing are at risk of losing their business if markets hit a rough patch, attendees at the IFA roadshow have been warned.
Friday, October 19th 2012, 7:18AM 7 Comments
by Niko Kloeten
Speaking at the event this week, Glen Wright and Jonathan Butler of NZ Funds Management discussed the increasingly prominent field of behavioural finance and how advisers can use its insights in their own businesses.
One of the central tenets of behavioural finance is that, contrary to standard financial theory, humans are not rational investors.
Even geniuses can find themselves victims of humanity’s irrational instincts; Butler used the example of Sir Isaac Newton, who lost £20,000 (£2.4 million in present day terms) investing in the South Sea Company bubble in 1720, having earlier sold out at a considerable gain.
Butler said investors have a natural tendency to buy high and sell low, highlighted by figures from research firm Dalbar showing that between 1987 and 2006 the S&P 500 Index returned 11.8% per year but investors only achieved 4.3%.
Trying to convince clients to stay invested during market gyrations has proven over the years to be “about as effective as telling a 12-year-old girl not to scream at a Justin Bieber concert”, he said.
“We’re trying to overwhelm thousands of years of DNA in our brain; we’ve got basically the same brain we had as cavemen. If we see something new we have to make the decision on whether we want to breed with it, eat it or run away.”
This fight-or-flight instinct means that fear is prioritised; Wright said that while traditional economic theory suggests investors view gains and losses equally, research has shown that investors dislike losses two to two-and-a-half times more than they like gains.
And he said financial advisers need to take this into account when designing portfolios, because enough of a loss can cause people to ditch their financial adviser and even quit investment markets altogether.
“We know clients can be invested for 10 years in shares and get a negative return; we just hope it’s not the decade coming up. I think it’s almost cruel and unusual punishment to invest in shares without some way of mitigating the downside risk.”
Wright said advisers need to be particularly careful during the first few months with new clients, to ensure they don’t suffer any big losses during this early stage.
For instance, NZ Funds invests only 40% of client funds initially, with 30% invested in six months’ time and the remaining 30% invested at the one-year mark.
“If clients invest with you and have a bad start they are more likely to leave and if they have a good start they are more likely to stay,” he said.
“Most clients will come in and tell you they want as much growth as possible but they don’t want any losses; they’re just diametrically opposed.”
Niko Kloeten can be contacted at firstname.lastname@example.org
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