Financially Speaking Podcast

Say What You Do; Do What You Say

Published on November 15, 2011

Behavioral economics, a body of research and knowledge developed over the past two decades, has helped financial advisors understand the investment behavior of clients.  Advisors are now better equipped to understand the reaction people have to investment events, but also to understand the mistakes that investors make.   A great deal of research confirms that investors buy and sell mutual funds at the wrong time.  Investors sell when there are large losses and buy after there have been large gains.  Now there is a psychological explanation for this phenomenon.   Before behavioral economics, observers would ask “Why in the world would you do that?”   After behavioral finance, observers understand why investors do that; and advisors use this understanding to prevent clients from making the same financial mistake over and over again.

The research and data confirming this is amazing.   Morningstar, and independent source of data and search for investments, has even developed data which reflects actual returns investors get as compared to total return of the fund, if they had not bought and sold at various times.  The return for investors is different from the return for the fund – there is a performance gap.  This happens because investors make poor investment decisions when buying and selling mutual funds.

Well, what about advisors?  Since they are people too, do they make the same mistakes?  Financial advisors are compelled to adopt a philosophy or belief system which they apply to investment recommendations to their clients.  There are only three methods to make investment decisions:   market timing, securities selection and asset allocation.  Some advisors believe they know how to successfully time the market; while others believe they have the tools to select the best performing investment prior to the performance.  Those who believe in asset allocation develop a diversified portfolio of various asset classes, and then monitor the qualitative elements of the portfolio.  Asset allocation doesn’t involve a whole lot of trading, while market timing and securities select do require active trading. 

About fifteen years ago, most banks and investment companies adopted Modern Portfolio Theory which explains the benefits of asset allocation.  Over the years, more and more investment salespeople and advisors have – supposedly – adopted asset allocation as their philosophy.  But do they really believe in and apply asset allocation to their practice?

Recent data indicates that 83% of assets going into mutual funds today are directed by financial advisors.  If there is a performance gap in mutual funds and if 83% of mutual fund investing is done by advisors, who is responsible for the poor results of trading mutual funds?   A recent article in the Wall St. Journal illustrated the point.  Advisors who used TD Ameritrade for client investments had an average of 26% allocated to bonds in October 2007-the stock market high point of the past decade.  As of March 9, 2009 - the low point for stocks-advisors had jacked up their bonds and cash to 51%!  Apparently, advisors are prone to making classic behavioral mistakes. 

It takes discipline and commitment to adopt a belief system and to stick to that belief in the face of insurmountable forces to changes what you belief.  Some advisors fold under pressure.  Other advisors say that they do and do what they say.

Tags: investment philosophy; investment belief system; investment decisions

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