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Traditional Finance: All Steak, No Sizzle

| May 27, 2015
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The original plan was to lead this post by posing a question like: can you imagine going to a restaurant, ordering a nice steak, and when it arrives, that’s it, just a HUGE STEAK?!!  No grilled asparagus, no mashed potatoes or other great sides to go with it??  Then I realized that there are likely many readers of this blog who would consider this scenario to be their dream come true.  Scratch the steak house example, bad analogy.  You know the old bible verse about man not being able to live on steak alone?  Or was it bread?  In any case, what I’m getting at is that investing, like many other matters in life, requires a healthy amount of balance.  You need some steak and a little bit of sizzle. With respect to investing specifically, I’m referring to a need for balance between two schools of finance theory:  Traditional Finance vs. Behavioral Finance.  Just as eating nothing but a steak would inevitably lead to digestive and heart issues (I’m not a doctor, I just play one on t.v.), when advisors adhere only to a Traditional Finance approach when dealing with clients and their portfolios, it can lead to sub-optimal outcomes and relationships.

So as to not overwhelm you with all of the academics behind this, here are the core characteristics and differences between Traditional and Behavioral Finance:

Traditional Finance outlines how investors should behave and make decisions.  It utilizes the concept of the Rational Economic Man or R.E.M.  The R.E.M. embodies all characteristics of Traditional Finance including:

·       Making rational investment decisions at all times, under all circumstances.

·       Having perfect and complete information about all topics and subjects.

·       Continuously updating probabilities of outcomes throughout any decision making process.

·       Acting out of self-interest and for profit maximization at all times, regardless of any social implications or values.  Investors act to maximize utility/satisfaction at every point.

·       Will always delay gratification in the short run to maximize long term value and utility.

·       Forgive the economics lingo, but investors are assumed to be risk averse and that their utility curves (sorry) are concave (picture half of a rainbow on a graph).  Translation?  Each additional unit of portfolio return that is achieved comes with less utility/satisfaction than the previous one.  For risk averse investors, losses hurt much more than gains feel good, if that makes sense.

In other words, within the world of Traditional Finance we are – or at least should be – robots.  If we are all robots this would then lead to completely efficient markets, which would lead to 100% rational investment solutions and decision making.  Sound kind of strange and unrealistic?  I agree.  The R.E.M. assumption certainly makes things more convenient for economists and researchers alike, in that it allows them to more easily explain investor behavior. It also makes it easier to quantify the results of their work.  It’s obviously pretty tough to quantify irrationality.  All that being said, viewing markets and investors through only this highly-restricted, robotic lens gives a skewed sense of reality.

This leads us to Behavioral Finance, which outlines how investors actually behave and make decisions under real life circumstances.  It recognizes that we are emotional beings and that in many (or most) instances, human emotions trump rational thinking.   A few core characteristics of an investor under the umbrella of Behavioral Finance include:

·       Decision making can be flawed at times, and is often not rational at all.  This is referred to as bounded rationality.

·       Short term needs or wants often outweigh long term goals.

·       Perfect knowledge of all subjects does not exist and no one can know everything about every topic.

·       Investor utility curves are often not concave (risk averse) and in fact, investors are often risk-seeking with convex utility curves (flip that half rainbow mentioned above up-side down to look like an Olympic ski jumping ramp).  For a risk-seeking investor, the higher the risk, the more attractive the investment, regardless of pain felt from losses.

·       Investors satisfice, meaning that they choose solutions that meet some minimal requirement or threshold, but do not ‘maximize’ utility/value/satisfaction.  In other words, they settle.

How about a couple of examples of real life client interactions to compare and contrast what Traditional and Behavioral Finance would predict.  In other words, what should happen vs. what actually does happen.

The Kevorkian Comeback: 

You remember good old Dr. Jack Kevorkian?  If not, let’s just say he specialized in putting people out of their misery.   What’s that?  Haven’t heard his name in 15 years?  Blast from the past?  Not for me.  I’d say I probably hear his name uttered in my office about once a month!  Why is that?  He represents a great ‘out’ for clients to do what they want to do rather than what they should do.  To illustrate, here is a hypothetical conversation between Michael Sanchez, who does all of our financial planning work, and a hypothetical client:

Michael:  So, as you can see in your retirement analysis, we’re showing a shortfall occurring around age 80 for you.

Client:  What does that mean?

Michael: You will have no money left at age 80.

Client:  What will we do at age 80 and where will we live?

Michael:  Not much, and under a bridge.

Client:  What can we do to prevent this?

Michael:  Maybe you could downsize your home as you don’t need all of the space that you currently have.  This would free up additional investment capital for you and could dramatically lower your property tax bill.  You could also decide between owning a lake house and an RV in retirement rather than the current plan to own both.  In the meantime, you could save more money each month and ratchet these savings up over time.  You could also decrease your planned spending in retirement.  Boy I’m on a roll today!  What do you think?

Client:  Nah, that all sounds terrible.  I think we’ll just keep doing what we’re doing and if we haven’t kicked the bucket by age 80 we’ll need to take that summer’s RV trip up to Kevorkian’s office.  That solves that problem.

Michael:  I’m not here to judge.  Not making these changes will put you in jeopardy of not achieving your original goals as you outlined them, but as long as you’re willing to kick-off early to help the plan, I’m good with that.  Thanks for chipping in!  I’ll put that Kevorkian visit on your list of to-do’s and include it in your follow-up letter.

Client:  Thanks Michael, please do!!

Sound ridiculous?  It does, but conversations like this happen in our office all the time.  Does Michael really have such a terrible bedside manner?  No, not at all, it was just fun to put those words in his mouth!  That said, we really do have eerily similar conversations with clients.  Traditional Finance suggests that this hypothetical client would most certainly forgo short term consumption for long term preservation. Making goal/lifestyle concessions should be a no-brainer to ensure that you don’t run out of money.  You can suggest that a client change their behavior or saving/spending habits till the cows come home.  That doesn’t mean that they will.  Often times they simply won’t or don’t.  Behavioral Finance suggests the opposite, and from what I’ve seen, the behavioral approach often wins out.

What’s that?  You want another example? 

The Sacred Cow

What happens when a client owns a stock (sacred cow) that they’ve inherited or have some personal connection with?  Many times it leads to irrational decision making and frustrating interactions.  It is particularly difficult if this stock happens to represent a large proportion of a client’s portfolio.  This can mean unnecessary unsystematic (company specific) risk and potential disaster. 

I have a former client whose father worked (has since passed away) at a manufacturing firm for his entire career.  The client was familiar with the company (who wouldn’t be if their dad worked there for 40 years?) in a general sense, not necessarily with the inner-workings of its financial statements.  The client had purchased the company’s stock over the years and had built a substantial position in addition to inheriting additional shares when his dad passed.  Soon thereafter, things had taken a turn for the worse for this company: missed earnings, analyst downgrades, spreads on their bonds widening, you name it.  Prior to all of this occurring, we had many conversations with the client about the risk that this stock represented in their portfolio and that a hedging or divestiture plan would likely be a smart idea to further diversify their portfolio.  Nothing was ever done.

After all of these negative events occurred with said company, I asked the client for their current opinion of what should happen with this investment.  He proceeded to cite 8-month-old analyst reports that had price targets 70% above the current, battered share price.  This phenomenon is referred to as Anchoring (attaching to a target price and hanging on to it) in Behavioral Finance.   This behavior also represents what is referred to as Confirmation Bias which means that you only seek out or acknowledge information/research that confirms a prior belief (old analyst reports).  The client was also unwilling to re-assess the current viability of the company and its share price now that all of these negative events had occurred (failure to update probabilities as new information becomes available).   Traditional Finance would assume that the client would reassess the position objectively and sell it to purchase a better investment if one is available.  That is the opposite of what occurred as the client decided hold the stock and be subject to all of its volatility.  The investment fell further, which of course led to what is called Loss Aversion which means that an investor will not sell a battered investment because doing so formally acknowledges the pain of the loss.  You know the old saying about leading a horse to water?  Bingo.  Hedging, Diversification, etc.?  The client didn’t want to hear it. 

So what’s the point?  Like many other things in life, managing money is both an art and science.  How do these conflicts between Traditional and Behavioral Finance get resolved in the real world?  It usually becomes a negotiation of sorts with the client to find an in-between solution that they can live with.    You don’t make many friends or keep clients for the long term by assuming that they are robots and will shun their emotions when making investment decisions.  It doesn’t do a client or an advisor any good to shove an investment strategy down the client’s throat that they are not likely to stick with over the long-term.  As we all know, money issues can bring out the very best and very worst in people and understanding how and why people make decisions is important in shaping successful investment outcomes.  This likely won’t be my last post relating to Behavioral Finance as it plays a huge role in my day to day dealings with clients.  To me, the topic is fascinating and can be  – forgive me – fun, at times. 

By: Andrew Gonski

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

The experiences described here may not be representative of any future experience of our clients, and should not be considered a recommendation of the advisor's services or abilities. Individual results will vary. Past performance is no guarantee of future results.  LPL
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