EC Dalbar, 2016: Yes, You Still Stink At Investing (Tips For Advisors)

As the markets decline, there is a slow realization that “this decline” is something more than a “buy the dip”opportunity.  As losses mount, the anxiety of loss begins to mount until individuals seek to “avert further loss” by selling.

As shown in the chart below, this behavioral trend runs counter-intuitive to the “buy low/sell high” investment rule.

(Click on image to enlarge)

Investor-Psychology-060616

In the end, we are just human. Despite the best of our intentions, it is nearly impossible for an individual to be devoid of the emotional biases that inevitably lead to poor investment decision-making over time. This is why all great investors have strict investment disciplines that they follow to reduce the impact of human emotions.

More importantly, despite studies that show that “buy and hold,” and “passive indexing” strategies, do indeed work over very long periods of time; the reality is that few will ever survive the downturns in order to see the benefits.

But then again, since the majority of American’s have little or no money with which to invest, maybe a bigger problem is the lack of financial education to begin with.

New Tips For Advisors

The Dalbar study delves into the importance of event recognition. Knowing that advisory clients are emotional and subject to emotional swings caused by market volatility, Dalbar suggests four successful practices to reduce harmful behaviors:

  1. Set Expectations below Market Indices: Change the threshold at which the fear of failure causes investors to abandon investment.

    Set reasonable expectations and do not permit expectations to be inferred from historical records, market indexes, personal experiences or media coverage. The average investor cannot be above average. Investors should understand this fact and not judge the performance of their portfolio based on broad market indices.

  2. Control Exposure to Risk: Include some form of portfolio protection that limits losses during market stresses.

    Explicit, reasonable expectations are best set by agreeing on a goal that consists of a predetermined level of risk and expected return. Keeping the focus on the goal and the probability of its success will divert attention away from frequent fluctuations that lead to imprudent actions

  3. Monitor Risk Tolerance: Periodically reevaluate investor’s tolerance for risk, recognizing that the tolerance depends on the prevailing circumstances and that these circumstances are subject to change.

    Even when presented as alternatives, investors intuitively seek both capital preservation and capital appreciation. Risk tolerance is the proper alignment of an investor’s need for preservation and desire for capital appreciation. Determination of risk tolerance is highly complex and is not rational, homogenous nor stable.

  4. Present forecasts in terms of probabilities: Simply stating that past performance is not predictive creates a reluctance to embark on an investment program.

    Provide credible information by specifying probabilities or ranges that create the necessary sense of caution without negative effects. Measuring progress based on a statistical probability enables the investor to make a rational choice among investments based on the probability of reward.

The challenge, of course, it understanding that the next major impact event, market reversion, will NOT HAVE the identical characteristics of the previous events. This is why comparing today’s market to that of 1994 or 2000 is pointless. As I have stated many times previously:

“When the crash ultimately comes the reasons will be different than they were in the past – only the outcome will remain same.”

However, it is extremely critical that careful judgment is used in identifying a potential impact event is imperative. As Howard Marks once stated:

“Being early is the same as being wrong.”

Advisors Must Take Action Before The Event

Dalbar’s data shows that the “cycle of loss” starts when the investor abandons their investments which is followed by a period of remorse as the markets recover (sells low). Of course, the investor eventually re-enters the market when their confidence is restored (buys high)Preventing this cycle requires having a plan in place beforehand.

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Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Streettalk Advisors, LLC expressly disclaims all liability in ...

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