Myopic loss aversion

Myopic loss aversion occurs when investors overreact to short-term losses at the expense of potential long-term gains. It’s based on the fact that people hate to lose more than they love to win. A sudden and significant drop in the market often triggers the reaction to bail out.

People who suffer from myopic loss aversion tend to overlook the fact that the stock markets are volatile. In recent years, the frequency of daily +/– 1 percent market volatility on the S&P 500 has increased dramatically. Investors who are accustomed to such volatility are less prone to get rattled by it.

Confirmation bias

Confirmation bias is the tendency to gravitate toward or interpret evidence as validation of one’s own beliefs or feelings. For example, many people subconsciously watch news channels or read newspapers and magazines that express opinions that align with their own beliefs.

You and your clients can reduce confirmation bias by becoming aware of it and seeking out different perspectives. For example, I watch a variety of news channels, some of which lean toward the left and others that lean toward the right in an attempt to get a more balanced view of what’s really going on. I don’t want to live in an echo chamber, because I don’t want my judgment and the advice I give to my clients tainted by confirmation bias. Clients benefit most from rational and balanced analyses of all facts, insights, and opinions.

Mental accounting

Mental accounting is the practice of conceptually separating money into different accounts base on subjective criteria, such as how a client got the money or what he plans to spend it on. Clients have a different attitude toward the funds in each account.

This haphazard categorization of money leads to trouble. For example, a client may accumulate considerable cash over the course of many years and believe that cash is always king.

To counter mental accounting, identify and explore any feelings and beliefs that are driving this behavior and challenge them with facts and rational argument.

Illusion of control

Illusion of control is the belief that a person has more control over events or outcomes than he really has. If you’ve ever pressed a button at a crosswalk more than once to get the traffic lights to change, you’ve succumbed to the illusion of control, thinking the more times you pressed the button, the faster the lights would change.

Having an illusion of control causes some clients to trade more actively or be overconfident in a belief they have when it’s based on insufficient knowledge and understanding. For example, an investor who has the illusion of control is more likely to fall victim to a get-rich-quick investment opportunity, thinking he has the inside track and that his investment has a huge upside and no downside.

Remind clients who are susceptible to the illusion of control that markets are inherently volatile. The only sure thing is that higher risk holds the potential for higher returns. If a client expects big earnings and is unaware of the risks, he needs to be informed of those risks. Ultimately, other factors beyond your client’s control determine the outcome.

Recent extrapolation bias

When a stock is hitting new highs day after day, people get excited. They want in. They’re lured by returns, and their greed gets the better of them. They’ve succumbed to recent extrapolation bias — the belief that recent performance is a sign of future results. This bias runs counter to the traditional wise warning that’s presented in nearly every prospectus: “Past performance is not indicative of future results.”

Extrapolation bias is common in any soaring investment. Just look at Bitcoin. I don’t know how many times clients have asked about it over the past year (2017–2018), but every time it’s with great desire. As I write this, the price has collapsed 70 percent from its highs. Those same clients don’t say, “Thank you” when I conduct their quarterly review. As soon as it’s down, they forget it even exists.

Hindsight bias

Hindsight bias, often referred to as “I told you so” bias, is the tendency of a person to overestimate his ability to predict the future by using as evidence an instance in which he happened to guess an event or outcome that was impossible to predict.

I’ve had a few prospective clients boast about how much money they made as investors. That’s great, but unfortunately it’s rarely true. An audit of the masterful investor’s portfolio invariably reveals mediocre performance, usually because the one great investment has already been sold and the money reinvested into something the investor conveniently failed to mention performed poorly.

Herd mentality

As with cows, sheep, and lemmings, herd mentality drives people to move en masse in a certain direction. Safety in numbers is the supposed reason behind this behavioral bias, but like the urban myth of herds of lemmings stampeding off cliffs to their certain death, investors often get caught up in stampedes that lead to massive losses.

When people are irrational, all sense flies out the window, and something else takes over. That something else is the remnant of the Neanderthal brain. I’m not being flippant about the paleo brain here. Extensive studies trace these irrational human behavioral responses to the limbic system (the paleomammalian cortex), and more specifically to the amygdala, which controls basic emotions, including fear, pleasure, and anger.

The only way to combat herd mentality is to create a plan and stick to it. The plan works like blinders on a horse to focus your client on moving forward instead of being drawn off course by the distractions of what other investors are doing.

Step 1: Acknowledge your client’s fear

You won’t get far in the conversation unless you level with your client right out of the gate. You’re competing with 24/7 news media, which is only interested in keeping eyeballs glued to the set during tumultuous times in order to drive ad revenue. Admit to your client that the sell-off appears scary, but explain that’s what the media want everyone to believe. It’s like watching an accident — people can’t look away. Acknowledge that it looks scary but is just business as usual, as proven through the history of the markets.

Step 2: Tell your client to take a deep, cleansing breath and smile

Okay, I know I live in Los Angeles, and we’re all yogis out here, but I wouldn’t include this advice unless it was absolutely effective. Before you can introduce rational or logical thought into a client’s mind, you have to secure a stable space to work within. Through deep breaths and smiling, the mind-body union is engaged, producing a grounding effect that naturally extends to encompass both you and your client.

Smiling after taking a deep breath triggers endorphins. Try it when you’re stressed out. Smiling, even when you don’t feel like doing so, brings forth calm and serenity from within.

Step 3: Introduce a rational argument

When you feel as though your client has backed away from the cliff’s edge, he’s ready to receive your rational argument. This technique is both popular and effective in quickly arresting the disorienting effects of a stock market meltdown.

Let your client know that you’re happy to sell all the holdings, but as with any portfolio management strategy, together you’ll need to also define the buy strategy. After all, selling to sit in cash is a portfolio action that wreaks more havoc on long-term portfolio total returns than any other investing decision. So, you need to proceed prudently. If you’re going to sell, when are you going to buy back in? What price or index thresholds do you reference to trigger this buying action?

This is your appeal to rational thought. The assumption is that markets will eventually stabilize, and when they do, when are you buying back in? Are you buying back in when the markets have recovered 5 percent from current levels? 10 percent, 20 percent? If you’re buying back into the positions after they’ve corrected 20 percent, then you’ve permanently lost that 20 percent gain, which is a permanent capital loss.

Permanent capital loss is the most dangerous risk around, but most investors subject themselves to it actively and routinely, even though it’s completely avoidable. All the investor needs to do to avoid permanent capital loss is to sit on his hands, look away, garden, or take a walk around the block.

Step 4: Have your client explain the strategy back to you

Having clients explain the strategy they’re requesting back to you is the best way to engage them in rational thought. I’ve had clients begin to explain the strategy of selling their positions and then buying back in when those positions have recovered 20 percent from current prices. When they’re done, I say something like, “Oh, is that what you really what?” and they don’t even know what they just said. It hasn’t quite clicked for them. And then, as if struck by a lightning bolt to the brain, they say, “No! Wait! I don’t want that!” Finally, eureka, they’ve got it, and the rational brain wins another battle over the paleo brain.

Calming common fears

During market meltdowns, clients often assume that their portfolios are directly correlated to the events they’re watching in the nightly news. If you’ve done your job properly, each client’s portfolio has much more diversification than what is reflected in the Dow Jones Industrial Average Index (DJIA), the Standard & Poor’s 500 Index (S&P 500), or the National Association of Securities Dealers Automated Quotations (NASDAQ) exchange. However, those three indexes are the ones highlighted every night on every new channel. If any or all of those indexes have tanked, your clients will feel the fear course through their veins.

To calm your clients’ fears, highlight portfolio holdings that have risen in value or, at the very least, have held their value when other markets are crashing. Don’t just talk about it. Show them on their statement or have them log in to their account so they can see for themselves. Nothing takes the place of hand-holding to reveal their exposure to risk — not the nightly news, not their friends’ portfolios — just what they hold in their account and how it has weathered the storm.

Your clients aren’t thinking about how their portfolios are constructed to handle market volatility. That’s your job, especially when times get tough. Jump into the deep end and wrap your life-saving arms around your clients. Show them what you see, and share with them what you know.

Reining in greed

The old saying “Pigs get fat, hogs get slaughtered” is always true in the financial markets. I’ve talked to many prospective clients over the years who’ve insisted that some private placement offering memorandum promising 12 percent annual returns with no risk is where they want to allocate significant portions of their investment savings. Who wouldn’t?

The truth is that risk and reward always meet in the battlefield of the global capital markets. There’s no free lunch, just lots of pretenders and con artists hoping that a sucker will forget all the rules and throw some cash their way. You have to protect your clients from these predators who live off the fact that people are prone to being greedy.

Greed is also found in the mundane. Portfolio positions held for many years during a bull market are hard to let go for most clients. Encourage clients to reconsider in the context of the big picture. Rebalancing their portfolio or offsetting profits with charitable contributions may be the more prudent course of action.