Investors tend to be reactive and risk averse when it comes to investing in stocks. And for good reason – when your money is on the line – you’re bound to feel like it’s a direct hit when the stock market doesn’t perform in your favor.

That being said, there's no question that demand for investments is driven by both reason and emotion.

Economic models are developed as a way to plan for the future, given real-world financial situations. With this modeled plan, a rational investor determines an amount that he or she will pay for an asset, based on the size and the risk of the future payout.

Emotions, however, can quickly lead investors to make decisions that are no longer consistent with the advisor-made economic models – and, in doing so, clients could become less likely to reach future financial goals. All because reason went out the door when emotion entered the room.

Why do we respond emotionally to investments?

One of the ancient regions of the human brain, known as the amygdala, has been identified as the source of our emotional response to loss. Even scientists who know that the amygdala is going to create a negative emotional response to a loss are unable to make that negative feeling go away. We may know rationally that a loss is simply part of investing in risky assets, but we can't entirely get rid of the emotional response that is hardwired into our brain. This battle between our rational prefrontal cortex and emotional amygdala over how to respond to a loss is a good example of the two-system theory of cognition.

What does this mean to investors and financial advisors?

A recent experiment found that when advisors recommended an investment that resulted in a loss, the first reaction a participant had was to blame the advisor. However, if participants trusted the expertise of the advisor, then they were much less likely to fire the advisor who made the losing recommendation. Demonstrating knowledge and competency – throughout the whole course of your client and advisor relationship – will help guide your client on the right path toward their goal, even if their emotional brain is telling them to jump ship.

Understandably so, this emotional effect appears to be particularly strong among clients who are getting close to retirement. As workers move into their mid-50s and 60s, they begin to pay more attention to the size of their nest egg. If they look at their quarterly statement and stocks have gone up by 20% over the last year, they're more likely than younger workers to want to take an investment risk. Conversely, if they look at their statement and see a loss, they're more prone to become risk averse.

How to navigate an investor’s risk tolerance

Time varying risk tolerance is the concept that investors are more risk tolerant when stocks are rising and, contrarily, risk averse after stock values are falling. Research shows that when risk tolerance is measured during a bull market, the average scores are significantly higher than when risk tolerance is measured after a market crash. An individual’s appetite for risk appears to change over time, and older clients may be particularly susceptible to time-varying risk tolerance.

Changing risk attitudes can be dangerous to a portfolio (some may say, a risk in itself). Let's consider this example below for how we normally rebalance a portfolio:

You begin with a 50/50 allocation of stocks and bonds. If the return on stocks is higher than the return on bonds, this allocation will get a little out of proportion. The stock percentage will be higher. In order to rebalance, you'll need to sell stocks and buy bonds. However, clients typically don’t wish to sell stocks when they're performing well.

On the opposite side of the equation, if stocks fall in value, then the portfolio becomes off balance because the portfolio now has a higher allocation to bonds. This means that you'll need to buy more stock in order to rebalance. And even rationally minded clients do not feel inclined to purchase more of an asset that just lost them money.

So, because of the emotional responses to gains and losses, most clients will want to do the opposite. Like it’s second nature to them, clients will want to sell stocks after they've fallen in value and buy stocks after they've gone up in price. Except, this practice will only lead to underperformance over time; since, the investor is essentially buying stocks when they have a higher valuation after they've gone up in price and selling stocks when they have a more attractive valuation. Unlike most other goods, people tend to like to pay more for stocks rather than buying them when they're on sale at a good price.

In fact, mutual fund studies have shown that investors lose as much as 1.5% in performance every year because they buy and sell stock mutual funds at the wrong times. Most of this underperformance occurs when investors sell stocks after a bear market. For example, as you can see in the following graphic, net new investments in stock mutual funds fell sharply after stock prices had fallen during the 2008 financial crisis. Investors who sold stock mutual funds in March of 2009 missed out on a 68% increase in the value of the S&P 500 by the end of the year. 

Stock Mutual Fund Monthly Flows

How to steer clients away from investor sentiment

Investors also appear to trade stocks that are popular. Stocks that have easily recognizable brand names, or stocks that have recently been in the news, are more likely to be traded by individual investors. This makes sense because an investor has probably only heard of a small fraction of publicly traded stocks. And the stocks they've heard of are the same stocks that other individual investors have heard of.

This concept is known as investor sentiment. Small investors tend to have positive or negative feelings about individual stocks, or the stock market in general, that change over time. Researchers have discovered that stocks that are owned primarily by small investors tend to have prices that are driven more by sentiment than the fundamentals of the company. For example, when a positive column is written about a stock in the Wall Street Journal, the price tends to go up immediately, and then the stock underperforms as it adjusts back to its fundamental value.

Clients will inevitably be attracted to stocks that appear in the news, and they're often motivated to trade based on news reports about a particular company. If the news is positive, they'll want to buy the stock; if the news is negative, they'll want to sell it. For clients who are particularly interested in trading individual stocks, advisors might consider allowing them to invest in these stocks using a small portion of their investment portfolio, using what is known as a core-satellite approach. While the core of the portfolio may be invested in a diversified portfolio of market securities, a small portion – possibly dependent on the size of the overall portfolio and the desires of the client – can be set aside for the satellite allocation to be invested in these other investment strategies, like the latest popular stocks.

WMCP® - Wealth Management Certified Professional®

The article you’ve just read was adapted from the behavioral finance curriculum in the Wealth Management Certified Professional® (WMCP®) education program developed by The American College of Financial Services. The WMCP® is designed for advisors serving a global marketplace where mass-affluent and high-net-worth individuals seek professionals with a true understanding of their unique needs and goals. To learn more about this designation, visit us here or watch this short video.

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