Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow, shared a wealth of information at the latest Morningstar Investment Conference in Chicago.
Here are brief notes on how behavioural psychology can be used for good by advisers and investors alike.
Looking at loss aversion.
The adviser needs to find some way to develop a "regret proof" policy--a policy someone can live with when things go badly. This reduces the chance that a client will capitulate at the wrong time and possibly move to another adviser.
Kahneman described a practice he had developed with colleagues to improve investor outcomes. The adviser would try to determine the client's loss aversion to create a measure of projected regret. People are told to imagine various bad scenarios and then questioned at what point do they think they would want to bail out.
The idea that we had was to develop what we called a ‘regret-proof policy. Even when things go badly, they are not going to rush to change their mind or change and to start over.
Kahneman described this idea as “regret minimization”. He noted that the optimal allocation for someone that is prone to regret and the optimal allocation for somebody that is not prone to regret are not the same.
This kind of “regret-proof policy” or “regret minimization” idea allows advisers to bring up things that people may not be thinking of, including the possibility of regret or the possibility of them wanting to change their mind.
In a sense, Kahneman was using loss aversion to create this measure of projected regret.
Kahneman found that even extremely wealthy people are loss-averse.
The questions to answer with brutal honesty are: When do you feel the pain? How much are you willing to lose? When do you get to the point at which you "want to bail". That's a more important benchmark than expected return or the glowing "story" of a stock or other investment.
Run client portfolios in two parts.
By doing so, you balance present and future risks.
One portfolio holds the assets the client is willing to risk, and the other is a much more conservative portfolio comprising what the client wants to protect. The portfolios are managed separately and clients get the reports individually.
One portfolio is for short-term money for paying bills, taxes and short-term goals like saving for a house. This is money you can't afford to lose, so you invest accordingly. You want this money in the safe bucket.
The second is for a longer-term horizon such as retirement. You can take more investment risk because you have more time and need to compound returns. You don't touch it until you really need it.
This is helpful for clients because no matter the market environment, one of the portfolios is likely doing well. Of course, financially, it's one portfolio, but framing it as two separate accounts helps clients understand and tolerate the risks better.
The role of the adviser as a therapist.
Asset allocation, in many ways, is the easy part. Helping clients set reasonable goals and adhere to their plan is the difficult part; it requires having in-depth, sometimes personal conversations with the client. One element of the process is broad framing; taking a comprehensive look at the client's present and desired future outcome.
Individuals tend to do very poorly guessing what stocks will do. Admitting you don't know is a very healthy step, but this admission leaves you with a great deal to do. You need to find out what the client's dreams are, what their fears are. And when bad things happen, you need to be there to help people stay on course.
Advisers should be realistic with investors about the potential outcomes. They need to help clients make informed decisions. By discussing the risks in advance, you are helping to inoculate clients; you are preparing them for what could happen.
You can view the original posts on Morningstar.com and Forbes and Think Advisor.
