Behavioral investing: Understanding your clients’ complacency Article added by Dave Scranton on March 24, 2011
Dave Scranton

Dave Scranton

Joined: February 23, 2011

It's been two full years now since the markets hit bottom on March 9, 2009, with the S&P 500 closing at 676 and the Dow falling to 6,547. A few months later in September, I talked with advisers about how to instill urgency in a rising market. Having ridden the market into the basement, investors were staying in — or jumping back in — in an attempt to recover their losses.

Now, two years later, the market is up almost 100 percent, and your clients have a totally different set of reasons for complacency. Most people I talk to — clients included — believe that the government policies, and the amount of money they're spending to carry out those policies, are not good. They feel the recovery is very slow or non-existent. Add to that the huge government debt, U.S. states and foreign countries in danger of defaulting, and the impact of world unrest on oil prices, and folks don't see a lot to feel great about.

And yet, there still seems to be a sense of complacency. How do we explain that and, more importantly, how do we address it? Well, the answer to the first question can be found in the science of behavioral investing. Basically, the concept of behavioral investing attempts to explain in psychological terms how human emotions affect the financial decisions of investors — and oftentimes their advisers.

Faulty wiring

Several recent studies indicate that over most periods, the average investor in the stock market earns a much lower return than the market overall. Over the very long term, the stock market averages 9 percent to 10 percent. Some of these studies say the average investor over this same time averages 6 percent to 7 percent, with some as low as 3 percent. So why do most investors perform so poorly?

The bottom line is that most of us are simply not "wired" to be successful investors. As human beings, we all have a highly emotional component to our decisions, especially when that decision concerns our life savings. That component is one of the primary reasons most people invest through the "rearview mirror." Only after a big run up in the stock market, like we're experiencing now, do many have the confidence to invest.

Unfortunately, they have missed out on most of the gains, and have entered the market when the next drop is much closer — often right around the corner. When the market descent begins, the average investor stays put. After all, they have been trained that the market "always comes back." Only after the drop becomes more significant, and the pain too great to bear, does the average investor "capitulate" and sell. The end result: They've just bought high and sold low, precisely the opposite of what they wanted to accomplish.
That American spirit

There's another factor that comes into play here. When it comes to our money, Americans are naturally inclined to be almost blindly optimistic. After all, experience teaches us that our country tends to handle challenges and come out stronger on the other side. But at times, unfounded optimism can lead investors astray. Some of the current wave of market optimism comes from the big Wall Street firms, some from advisers who unknowingly are using biased research, and some from the media.

Now, don't get me wrong — optimism is a wonderful quality in the human spirit. Few great accomplishments have been achieved without the fuel of optimism. Unfortunately, you cannot will the markets to rise with optimism alone. One irrefutable fact exists: We have been in a secular bear market since 2000. And when the tide goes out, all the boats fall.

It’s our job to turn this tide of emotion and optimism, and help our clients understand that this could be the best time for them to make a change. Shatter complacency, and help your clients start moving to safety.
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