Fear is often the single biggest obstacle to long-term investing success. When market uncertainty hits, investors naturally focus on recent losses and sensational headlines rather than their long-term goals. In today’s FA Alpha Daily, we look at how advisors can help clients navigate market anxiety and stay on track.
FA Alpha Daily:
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Over two decades have passed since Daniel Kahneman won the Nobel Memorial Prize in Economic Sciences.
For those of you who are unfamiliar with him, Kahneman won in 2002 because his research with Amos Tversky contributed greatly to economics and led to the creation of prospect theory.
While prospect theory was conceived in 1979, Kahneman and Tversky’s work continues to remain relevant today.
It Hurts More to Lose than It Feels Good to Win
Tversky and Kahneman’s research revealed that a person’s reasoning can shift depending on how a situation is framed. This research became known as “prospect theory,” which describes how people weigh gains and losses differently.
Prospect theory opened the door to many other ideas in behavioral finance, including loss aversion—the tendency to value perceived losses more heavily than gains of the same size.
In other words, it hurts more to lose than it feels good to win.
As an advisor, you’ve likely seen this play out firsthand. For many investors, the biggest obstacle to good outcomes isn’t the market. It’s their own psychology.
They tend to sell after prices have already fallen, even when their longer-term gains are substantial. The pain of watching a portfolio drop by double digits can easily overwhelm the satisfaction of years of growth.
Photo from Unsplash
Kahneman and Tversky’s work also covered cognitive biases—mental shortcuts the brain develops to speed up thinking. Coincidentally, these shorts can also lead to irrational decisions.
Biases are one of the biggest reasons that lead investors to make rash decisions… and it isn’t entirely their fault.
Media outlets are skilled at sensationalizing stories to attract views, which pushes everyday investors toward rash and uninformed decisions.
Kahneman and Tversky also touched on what they call the “availability heuristic.”
When people make decisions, they lean on whatever information comes to mind fastest, even when it isn’t the best available information.
If that information comes from an unreliable source, the decision is even more likely to go wrong.
The same scenario plays out among your prospects and clients. They tend to react to the most readily available or recent piece of information they come across… and sometimes, that becomes the basis for haphazard decisions.
No one can completely escape their biases, but these traps can be fought off.
That’s where you come in…
Helping Clients Fight the Fear of Losing
As a financial advisor, it’s part of your job to be a steadying presence for your clients in times of misinformation, confusion, and panic.
Not everyone publishing news has your clients’ best interests in mind, and some stories exist only to capture attention (We talked about this in a recent webinar. Watch it here).
Helping clients steer clear of misleading information sets them up to make better decisions.
It’s also crucial to help clients identify their biases, and the best way to do that is to make them aware that such biases exist. Once clients know what to look for, they can recognize that in their own thinking.
Aside from these, other practical steps you can take to help clients include:
- Talking about loss aversion and how it can affect how they view their finances, assets, financial goals, and investments.
- Encouraging them to pause before making major financial decisions, especially in times of sell-offs or widespread market volatility.
Unfortunately, sensational headlines and market noise will always be there to induce stress and anxiety among your clients.
However, that doesn’t mean they’re doomed. Their best defense against a rash decision made under duress is a calm and informed financial advisor guiding them.
Best regards,
Joel Litman & Rob Spivey
Chief Investment Officer &
Director of Research
at Valens Research
Today’s article only scratches the surface of what we share with our FA Alpha Members. If you want to get an in-depth analysis of market trends, uncover undervalued stocks, and more, become an FA Alpha Member today.