The measurement of effect of investor behavior for the past 21 years has demonstrated that the greatest underperformance occurs in the periods following severe market stresses. The Quantitative Analysis of Investor Behavior (“QAIB”) has chronicled the fact that investor’s reaction to market stresses are caused by psychological factors such as loss aversion, narrow framing, herding and media response.

Fortunately, these psychological factors are not immediate, but usually have the effect in the months following the stress. This delayed reaction is an opportunity to positively influence the performance-robbing behaviors.

The 2015 edition of QAIB describes effective ways of preparing for and controlling investors’ reaction to market stresses.

Lessons from the past

After more than two decades of evaluation, it has been shown that preparing investors for market stress before the fact is ineffective.

First is the catch 22 of investor behavior. On one hand if preparation is going to overcome the psychological behavior, it must be intense and frequent so that it survives the shock of the market stress. This is a catch 22 because such preparation will create other reactions that result in underperformance. These include delaying investment decisions, over-reacting to modest changes or complete avoidance of an investment program.

The second reason that preparing investors is ineffective is that the circumstances for each stress are very different. Preparing for a dot com crash is vastly different from 1987 or 2008.

Best practices

Preparing investors for market stress does not solve the problem, so a better course of action is to prepare professionals for these eventualities.

The 2015 QAIB lays out four actions that professionals can take to prepare to intervene before investors make regrettable mistakes. In summary, these four actions are:

• Get out ahead by recognizing the market stress event.
• Take the risk that the market stress will not occur (false alarms will happen).
• Deliver calming messages at the time they are needed.
• Develop a plan that can be quickly put into effect when the market stress is detected.

Emergency action

What if the emergency is here?

The most effective short term measure for investors during a market stress is a risk tolerance process. Investors will be convinced that the professional is helping and the process will create perspective without seeming void of substance or confusing.

It is critical to realize that individual risk tolerances change and particularly so during time of stress. Performing a meaningful risk tolerance assessment does require a process that goes beyond the simplified version used for regulatory compliance.