Thursday, December 8, 2016

Behavioral Finance and the Two Lane Highway

Even though the “Robo-Advisors” would disagree with me, today I would argue that in this day and age the most important thing a financial professional can do is relate to the “art” and not the “science” of their profession.  In other words, the most successful financial professionals I have ever worked with would agree that it is about the art of simplification, analogies, storytelling, managing clients’ emotions so they make healthy financial decisions, and to help them through good times and bad times.  I do believe the “science” of algorithms, Monte Carlo Analysis, alpha, beta, sharpe ratios, etc.; they are all important, but should they take a backseat to the “art” of BEHAVIORAL FINANCE?  Let me give an example of a simple behavioral analogy I like to use in financial professional and client seminars.  

A fitting analogy is that buying high and selling low in the stock market is a lot like driving down a two lane highway. Pretend you are sitting in the right lane and both lanes are at a standstill. What do you do when you notice the left lane is starting to move? You move into the left lane. Shortly after that, the left lane always comes to a standstill. Well, shortly after that is typically when you see the right lane starting to move forward. So then what do you do? You move back into the right lane. What happens to the right lane at that point in time? It comes to a standstill. But of course, that is when the left lane opens up and you hopelessly jump back into the left lane. Many of us do this over and over again to then realize that it is a losing proposition. Why does this phenomenon happen with traffic where it seems like you cannot win by switching from lane to lane? Because everybody else has the same idea of jumping into the same lane as you, the moving lane, and eventually the bubble bursts and traffic comes to a standstill. Due to the fact that everyone moved from the other lane and thus "emptied" it, the other lane opens up. At that point, everybody jumps back into that other lane and you create another "bubble“ that stalls traffic. 

That is very analogous to how the stock market behaves. Because people buy high and sell low by chasing each other, they actually do not perform as well as what the market actually does over the long haul. 

Some of the most profound studies in this area have been done by the financial services market research firm, DALBAR. Dalbar recently launched their 22nd study on investment returns versus the returns actually experienced by investors. They found that over the 20-year period of time ending December 31, 2015, the average return for equity mutual fund investors was only 4.67% even though the average in the S&P 500 was 8.19%. Thus, a 3.52% "gap" in investment returns versus investor returns. This "gap" on a $100,000 investment can mean significant damage to a pre-retirees’ or retirees’ retirement portfolio. For example, if that $100,000 gets 4.67% over a 20-year period of time versus 8.19% over a 20-year period of time that is the difference of having $249,140 versus $482,772 by the end. This is a difference of $233,632 by "buying high and selling low." And this does not include the negative impacts of taxes and trading costs for the investor that moves in and out of the market.

So again, whether it is providing simplification and analogies like the two lane highway or managing a clients emotions so they don’t “buy high” and “sell low,” today this is one of the most important topics a financial professional can use to “sharpen their axe” which is the study of Behavioral Finance.  

Learn more in the full white paper "What Robo-Advisors Cannot Do That You Can. An Introduction to Behavioral Finance," by Charlie Gipple, CLU, ChFC. 
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