Why Today’s Successful Financial Advisor Needs to be a Behavioral Coach
“The investor’s chief problem—and his worst enemy—is likely to be himself.” Benjamin Graham
Long before it became a field of study in academia, legendary investor Benjamin Graham knew a thing or two about behavioral finance. Graham said, “In the end, how your investments behave is much less important than how you behave.”
Graham is joined by other legendary investors such as Warren Buffett, Peter Lynch, and Shelby Davis, who all believe that it’s not investments that cause people to lose money; it’s people who cause people to lose money.
Research into behavioral finance, which began in earnest in the 1970s, has revealed that investors are not nearly as rational as once thought. Traditional finance theories such as the efficient market hypothesis (EMH) relied heavily on the rationality of investors to try to prove that stocks are most often fairly priced— because any new information about a company is already discounted in a company’s value.
However, as behavioral finance researchers found, traditional economic models don’t reflect the reality that humans are far less rational than presumed. The research found that our tendency to make irrational investment decisions is not arbitrary; it is in many ways methodical and predictable, especially in certain situations.
For financial advisors, understanding how emotional and intellectual processes combine to influence investors’ decisions offers the opportunity to help their clients avoid costly mistakes and optimize investment outcomes.
In today’s market environment, an advisor plays no more valuable role than that of a behavioral coach, helping clients understand how their biases control their decision-making and how to remove their emotions from the equation.
The Costly Consequences of Behavioral Mistakes
There are countless studies and examples illustrating the consequences of suboptimal decision-making caused by behavioral mistakes. A study by behavioral finance software provider Oxford Risk in 2023 found that investors could lose roughly 3% in returns every year due to emotionally driven investing decisions. During periods of high stress, like the pandemic, such losses can rise to 6–7%.
Or consider an example of investor underperformance from 1986 till 2022. A $10,000 investment made in 1986 could grow to as much as $177,410 in 36 years if an investor chose to remain fully invested. But if emotions get the better of the investor, the returns begin to decline quite significantly. If in those 36 years, the investor missed just the 10 best days for the S&P 500, the investment value drops to $83,030. If they missed the best 20 days, it drops to $52,731. 30 days, $35,549. 40 days, $24,842. 50 days, $17,961. And finally, if the investor missed the best 60 days during the 36-year period, the investment value falls to $13,303.
Behavioral Biases: The Emotional Drivers of Poor Decisions
Behavioral finance researchers found that most emotionally based decisions are triggered by biases. We all have deeply ingrained biases that reside subconsciously in our psyche. Some behavioral biases are cognitive-related, stemming from information we process every day, while other biases are emotionally based, stemming from our impulses or intuition. Generally, our biases help guide decisions as we navigate our everyday lives.
However, in the realm of investing, biases tend to work against us because they can cloud perspective, which is sorely needed during times of stress. As financial advisors, you must contend with as many as nine or ten different biases that could be controlling your clients’ emotions and actions.
Key biases include:
RECENCY BIAS: One of the more common behavioral biases, recency bias, causes clients to think that the way things are now or what happened recently is the way they most likely will be. Recency bias typically reveals itself during volatile or down markets with an unhealthy tendency to focus on negative returns. Clients convinced that a market decline will continue are likely to make emotionally charged decisions to flee the market.
CONFIRMATION BIAS: A more subtle but equally dangerous bias, confirmation bias, causes clients to seek out information that supports their preconceived notions, ignoring perspectives that can refute them. If clients believe the market will continue to decline, they will only consider information supporting that perception and act accordingly.
LOSS-AVERSION: One of the more perplexing biases, loss aversion, is an affliction that causes investors to feel the pain of losses far more than they feel positive about gains. They would rather sell investments to avoid watching account balances evaporate than focus on the long-term return potential.
There are several other types of behavioral biases, including framing bias, anchoring bias, mental accounting bias, and overconfidence. They’re all independent of each other, but they also can work in conjunction with each other, which makes it important to study them and understand them in the context of how your clients make decisions.
The True Value of a Financial Advisor
A study by the Vanguard Group found that having a quality advisor can improve investment performance by as much as three percentage points annually. Vanguard attributes that advantage to the value an advisor can bring to an advisory relationship as a financial counselor and behavioral coach, helping clients stick with their long-term strategy while avoiding costly mistakes.
In helping clients confront their biases and overcome emotionally charged decision-making, advisors have the advantage of context and perspective, which needs to be shared with clients. While troubling, a sudden 1,500-point drop in the stock market may likely have little if any impact on a client’s long-term investment performance.
Reminding clients that, since 2000, the S&P 500 has gained on average, more than 8% one month following a market correction bottom and then going on to gain more than 24% the following year is a way to put a short-lived market downturn in perspective.
WHEN THE MARKET HIT BOTTOM IN 2008…
Advisors have context for a severe bear market crash that can erase 40% of portfolio value. Following the 2008 market crash, many investors feared all was lost and that their long-term goals had turned into pipedreams. The chart below shows how a $100,000, 60/40 portfolio performed from 2004 through the 2008 crash. Can anyone blame them for feeling a deep sense of dread about their future?
The chart below shows the stock market bottom in 2008—the capitulation stage of the bear market—which is where many investors hit the eject button and fled the market at the worst possible time.
Growth of $1,000 invested in the S&P 500, 1956-2003
…AND THE LONG-TERM PATH TO POTENTIAL WEALTH CREATION AFTER THE BEAR MARKET BOTTOM
As behavioral coaches, advisors should reframe the conversation and place the circumstances in the proper context of the long-term picture. The following chart based on a study from Morningside shows that, from that point of the market bottom, there is a 75% to 95% probability that a $100,000 investment could grow to $1 million in 20 years, or $2 million goal in 30 years.
Having conversations about how the market works and the historical context of market cycles is a key to helping your clients maintain the proper perspective. More importantly, keeping them laser-focused on their long-term objectives rather than the market’s short-term fluctuations helps them ignore their biases and maintain the discipline of their long-term strategy.
This objective is a focus of Howard Capital Management (HCM) as an asset manager — to provide a quantitative, mathematical approach to investing that eliminates emotional decision-making in an effort to generate more consistent outcomes for the end investor.
The HCM-BuyLine®
Howard Capital Management (HCM) trades based on a proprietary indicator, the HCM-BuyLine®. This system is designed to identify clear market trends in an effort to seek optimal portfolio allocations through buy and sell decisions based on those trends. Emotions have no place in our process.
The HCM-BuyLine® has been tracking and identifying trends for three decades, assisting HCM in sidestepping catastrophic market declines in 2000, 2008, and 2020. To learn more about the HCM-BuyLine® and how it is used to tactically manage mutual funds and ETFs, please click here.
Sources:
- https://1finance.co.in/magazine/how-emotional-investing-triggers-bad-financial-decisions/
- https://www.fidelity.ca/en/investor-education/time-stock-market/
- https://www.visualcapitalist.com/sp/roller-coaster-of-emotional-investing/
- https://www.ssga.com/library-content/pdfs/etf/us/how-to-avoid-emotional-investing-when-markets-are-volatile.pdf
- https://www.magnifymoney.com/news/emotional-investing/
About Vance Howard
Vance Howard’s vision for HCM originated after seeing the devastating financial losses investors suffered during the stock market crash of 1987, an event precipitated in part by computer program trading and investor panic. In an effort to help investors monitor changing market conditions, he developed the HCM-BuyLine®, a proprietary math-driven indicator, designed with the goal of reducing the impacts of emotional investment decisions.
About Howard Capital Management
Howard Capital Management, Inc. (HCM) is a SEC-Registered Investment Advisory Firm founded by Vance Howard, which offers professional money management services to private clients, financial advisors, and registered investment advisors through a suite of separately managed accounts, retirement tools, self-directed brokerage accounts, proprietary mutual funds, and ETFs.
For more information, financial advisors should contact their wholesaler by contacting Howard Capital Management at www.howardcm.com or 770-642-4902.
HCM Indicators. The HCM-BuyLine® (the “Indicator”) is a proprietary indicator used to assist in determining when to buy and sell securities. When the Indicators identify signs of a rising market, HCM then identifies the particular security(ies) that HCM believes have the best return potentials in the current market from the universe of assets available in each given model and signals to invest in them. When the Indicators identify signs of a declining market, the Indicators signal to move clients’ investments to less risky alternatives. Not every signal generated by the Indicators will result in a profitable trade. There will be times when following the Indicators results in a loss. An important goal of the Indicators is to outperform the market on a long-term basis. The reason is the mathematics of gains and losses. A portfolio which suffers a 30% loss takes a 43% gain to return to the previous portfolio value. The Indicators are a reactive in nature, not proactive. They are not designed to catch the first 5–10% of a bull or bear market. Ideally, they will avoid most of the downtrends and catch the bulk of the uptrends. There may be times when the use of the Indicators will result in a loss when HCM re-enters the market. Other times there may be a modest positive impact. When severe downtrends occur, however, such as in 2000-2002 and 2007-2008, the Indicators have the potential to make a significant difference in portfolio performance. Naturally, there can be no guarantee that the Indicators will perform as anticipated. The Indicators do not generate stop-loss orders that automatically sell securities in the portfolio at a certain price. As a result, use of the Indicators will not necessarily limit your losses to the desired amounts due to the limitations of the Indicators, market conditions, and delays in executing orders.
Disclosure:
Investors should carefully consider the investment objectives, risks, charges, and expenses of Mutual Funds and ETFs. This and other important information about the Funds are contained in the prospectus, which can be obtained at https://www.howardcmfunds.com or by calling 770-642-4902. The prospectus should be read carefully before investing.
HCM Funds are distributed by Northern Lights Distributors, LLC, member FINRA/ SIPC. Northern Lights Distributors, LLC and Howard Capital Management, Inc. are not affiliated.
Important Risk Information:
Investors should carefully consider the investment objectives, risks, charges, and expenses of Mutual Funds and ETFs. This and other important information about the Funds are contained in the prospectus, which can be obtained at https://www.howardcmfunds.com or by calling 770- 642-4902. The prospectus should be read carefully before investing. HCM Funds are distributed by Northern Lights Distributors, LLC, member FINRA/ SIPC. Northern Lights Distributors, LLC and Howard Capital Management, Inc. are not affiliated.
Howard Capital Management, Inc. (“HCM”) is registered with the SEC and only transacts business where it is properly registered or is otherwise exempt from registration. SEC registration does not constitute an endorsement of the firm by the Commission, nor does it indicate that the advisor has attained a particular level of skill or ability. Changes in investment strategies, contributions or withdrawals, and economic conditions may materially alter the performance of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for an investor’s portfolio.
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