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Psychologists Daniel Kahneman and Amos Tversky won the Nobel prize in economics for developing a theoretical framework to show how we make often irrational decisions when faced with real life economic trade-offs. As a part of their prospect theory research, they showed that we are naturally loss averse; this means we experience more negative feelings associated with a loss, than we do positive feelings for a comparable gain. For instance, we feel worse about losing $100, than we feel happy for winning $100. Yet despite the recognition that this research has received, are we ignoring it in the financial planning world? Simply put: If our clients feel worse about a loss than they feel good about a comparable gain, shouldn't we be more proactive about protecting them from losses, even at the risk of giving up more gains?

The inspiration for today's blog post comes from a recent post at the Squared Away blog hosted by the Financial Security Project at Boston College, which discussed upcoming research about "How Emotions Drive Investing". I'll be writing further about the results of this new research itself at a later date; but the blog did start me thinking about some of the basic principles we've learned already from behavioral finance research, including our tendency for loss aversion.

As mentioned earlier, loss aversion represents our tendency to experience more negative feelings for a loss than we feel positive feelings for a comparable gain; it feels worse to lose $100 than it feels good to make $100. Accordingly, we essentially need to have an expectation up front that our gains will exceed our losses by some sufficient amount, before we're willing to take an uncertain risk.

Yet when I look at our standard advice as financial planners to clients who are afraid in risky situations - stay invested and stay the course - I can't help but wonder if we're ignoring natural investing and human tendencies to our own detriment. If clients experience more negative feelings about a loss than positive feelings about a gain, that conversely implies that they would experience more regret about failing to avoid a loss than they would about accidentally avoiding a gain. In other words, it implies that the client who is worried about markets and gets out before anything happens would be excessively happy about avoiding a subsequent disaster, to a greater extent than the client would be unhappy if the market turned out to go up.

This in turn feeds into another topic I have written about recently, "Why Is It ALWAYS Bad To Get Out Of The Markets In Times Of Risk?" As I discussed in that blog post, I find that we often confuse the impact of getting out of the markets AFTER a crash, from getting out of the markets BEFORE any crash has happened, because we fear it might be coming. The standard financial planning response is "yeah, but what if the markets go up?" Yet the research on loss aversion implies a clear answer: "Even if the markets do go up, our clients would regret it more if they stayed in and the markets went down!"

I wonder if part of the reason clients are so hard to manage is actually because we reinforce this negative cycle. Clients feel worried in times of economic distress and fear something bad will happen; we tell them not to worry and to stay invested; the bad thing happens, reinforcing that the client is right and the planner was wrong, in the midst of a stressful emotional environment; and even if the planner is later "proven right" because the market recovers, it doesn't help! If we experience more stress for a loss than we do joy for a comparable gain, then that means a portfolio that goes from $100,000 to $90,000 and back to $100,000 may be even, but emotionally our clients psychologically lost more sleep in the $10,000 decline than they gained in relief with the $10,000 recovery gain! In turn, this means that ongoing gyrations in the market steadily erode client comfort levels and contribute to rising stress, even if the portfolio is treading water and recovering its losses.

What would the alternative look like? Imagine a world where we celebrated the disasters our clients avoided, the goals we secured, and only secondarily acknowledged how we helped them get more, more, and more return? Even if we didn't maximize the client's return, removing severe downturns from the equation can help them live a happier life, reach goals in a more stable manner with less uncertainty. And who knows, maybe if we pay more attention to avoiding economic catastrophes, we might even mellow the extent of the bubbles that form in the first place. To say the least, though, at least we can create a world where our clients' biggest regrets are associated with the extra wealth they didn't make, rather than the real wealth they actually lost. Would that really be so bad?

So what do you think? Are we underestimating the emotional impact that loss aversion implies? Should we really be helping clients avoid losses more proactive, because the regret of not avoiding the loss may be greater than the regret of getting out and accidentally missing a gain?

  • Patrick Crook

    It would seem obvious that the protection of assets deserves as much attention as the accumulation of them. I find it astonishing that after the countless examples of irreversible loss suffered by markets throughout history, the buy & hope approach remains the standard practiced by most in this business.

  • Eliot Weissberg

    Michael, this blog is dead on correct in many ways. Goal objective is the name of the game, not staying the course. Also we owe it to our clients to stay in business. Therefore we need to keep clients too. This is also why Dalbar shows how poor clients do. They are normally over risked.

  • Andrew H

    This is a very troublesome topic and one that is unlikely to ever have a perfect answer. Of COURSE it would be wonderful to move money out of the markets ahead of any turmoil. And I wholeheartedly agree from my experience with clients, and frankly, human beings in general that they would all be perfectly content with having missed out on gains of 10% if it meant they may also avoid a 10% drop. There are a number of problems with this methodology for managing clients as I see it, though.

    First, it is very difficult (if not impossible, based on volumes of academic research) to devise a viable strategy for determining where that point is at which one pulls the trigger for the client. Sure, we could just pre-determine a maximum pain point client by client, but due to their typically seriously bad grasp of markets this could very easily be an arbitrary number.

    Bt let’s say we decide with Client X that this point is -10%. And now let’s say that this trigger point is reached…now what? At what point do we reenter? Once the markets have rebounded to their previous point plus some amount? Some percentage positive movement? Here there be dragons…

    I know I used an over-simplified example but countless others with armies of Ivy League finance grads at their disposal and trading rooms that look like NASA ground control on steroids have tried and failed to successfully do this.

    And before anyone jumps on me by saying that the metric for determining success and failure of “risk management” strategies is benchmarking against a risk adjusted index and NOT client “happiness,” well, I ask you, is the role of a fiduciary to pander to client short-term happiness? Or is it to do our very best to help them achieve goals. And I wholeheartedly believe that it is exceedingly difficult to help a client achieve their goals through shark-infested market timing strategies. Especially when one considers not only foregone gains, but also increased risk due to mis-timed trades, transaction costs and the bite of Uncle Sam.

    The real name of the game is proper, in-depth, regularly reviewed and updated risk tolerance assessment. It sometimes takes years to really get a handle on what a clients tolerance for risk is, but once you hit that sweet spot, clients only need a little hand-holding here and there and are rather easy to manage. This coupled with proper rebalancing (please do not confuse this with buy and hold/hope!!!), and investor education does wonders for client happiness as well as their bottom lines and goal-attainment.

  • Wade Pfau

    Yes, this is an interesting issue. It does seemingly suggest a reason for people to consider reducing their stock allocations when market valuations become too high.

    But more generally, a direction which a few of your recently blog posts have been taking, and which I’ve been exploring as well, is that perhaps high stock allocations are not so necessary after all. Certainly, the 50-75% stocks for retirees advice coming from the Trinity study and its brethren maybe unnecessary and psychologically damaging. I’ll have short paper in the September 2011 “Between the Issues” of the Journal of Financial Planning looking at how often lower stock allocations are “nearly optimal” in that they will support a withdrawal rate that is just slightly lower than the optimal stock allocation. That might also have the benefit of making loss averse retirees feel less terrible about market gyrations.

  • Joseph Alotta

    Hi Michael,

    I see consumerism all over your basic premis. If clients want X, then we should give them X. By doing this we are just making ourselves order takers and not sources of wisdom.

    Rather than focus on giving my clients what they want, I try to give them what I think they would want if they had the education and the experience that I have.

    Did my father always give me what I wanted? No. But he helped me make the better choice and was there with me when the going got rough.



    • Patrick Crook

      Why would you assume that the better choice will always be to stay the course? Is the US market somehow magically immune to the grinding, multi-decade bear markets of the type that have crushed investors throughout history? I wonder how many Japanese advisor/market cheerleaders have survived the last couple of decades.

      I don’t advocate anyone being a perma-bear or a Kudlow-esque happy buffoon. But it’s a good idea to have a plan in place just in case things don’t work out in a way that conforms to your expectations.

  • Kay Conheady

    My view is slightly different…it isn’t what the client will like more or dislike more that matters…I believe that we should help our clients avoid steep losses that take a decade or two (or more) to recover. Based on a P/E10 ratio in the high 30’s, it was entirely predictable in 1998 that the market would extract steep losses that would take more than a decade to recoup (the 2007 market high was not sustained so doesn’t count) – we couldn’t know exactly when the losses would start to pile up (2000-2002) but we could know it was definitely coming. As advisers we should definitely be using available data to help our clients avoid losses that take half a working career – or a retirement – to undo.

    My 2 cents,

    • Abigail

      Great answer Kay. This is really getting to the heart of the matter for the average American investor. For most of us every dollar invested represents money earned working for an hourly wage and then carefully budgeting to be able to invest for our future. Watching the savings of many years of hard work and sacrifice disappear in a matter of weeks or months, and knowing that if the market does not decide to be kind again in a reasonable time frame that our working years are limited, is a crushing experience. In spite of promises from investment advisers that equities are the only real way to make to money, at the bottom of every prospectus we are reminded that “past history is no guarantee of future gains.”

      Throwing in my 2 cents with your 2 cents,


  • Allan Ward

    I was having a conversation with someone yesterday about the pain of loss being greater than the joy of gains.

    The value proposition of my financial planning business is based around achieving goals over time. If I can make the journey smoother for my clients, with less stress, I think that’s something to aim for. For many people the goal is not to get the ‘best’ returns, but to achieve their goals.

    Of course, one of the other problems is convincing clients to rebalance or reduce their equity exposure when things are going well!

  • Bobbie Munroe

    I’m with Andrew on this. I believe it would be very difficult to develop a manageable system and “when to sell” “when to buy” would be hard to determine. If we are to sell when prospects are questionable, I could make an arguement that that means I should take everyone out now. We are looking forward to a very difficult decade following a very difficult few years. The US debt issue will weigh heavily on us going forward and any fix will have it’s own unpleasant repercussions.

    I don’t take more risk than the client needs to reach their goals. If that means only 30% equities, horray. If that means 70% equities, so be it. I’m pretty sure they will be unhappy if they run out of money at 80.

    So now we come to Allan’s comments. He had a conversation with the client. Excellent! The big elephant is in the room so let’s talk about it. You will feel more pain with a loss but that is when I really earn my fee. I am here to help you negotiate your emotions during those downturns. And I’ve made sure from the very beginning (especially important with such volatile markets) that you understood we would experience such times. I’ll remind you that, when you weren’t in emotional chaos, you realized that the investment strategy we are using was implemented because it is the one that, in the long run, will help you reach your goals.

    Finally, there are some real ways to mitigate the pain of loss. Most of our retirees need to have some good exposure to growth/equities in their portfolios if we expect them to live 30 years in retirement. So we make sure that they have enough cash on hand to combine with income so that they need not sell for at least 3 years. If the market is doing well at the end of the year, we replenish the cash. If not, we wait. For those who are still working, we have boring, substantial emergency funds. Having that cash on hand makes it much easier to weather the storm emotionally. Of course, if you need to sell some investments to make the next mortgage payment, you are a wreck.

    So with proper preparation, we cannot avoid the losses but we can reduce the negative emotions they create. Hey, perhaps we can even get some people to buy. Now that is a way to make some money.

  • Nathan Gehring

    I think you’ve raised a very interesting question here, Michael, in particular the first half of your post. Unquestionably we need to be able to account for our clients’ behaviors and emotions.

    So do we do that through behavioral and emotional shaping and trying to help our clients’ manage their behaviors after the fact? Or do we do so by accounting for the behaviors and emotions in advance, as you suggest? I suppose the answer to that question lies in answering which option would ultimately help clients best.

    I believe we need to begin accounting for behavioral issues far more than by only trying to help clients deal with their emotions and the behaviors those might cause. The research is mounting. Somehow we need to figure out how to include this in our body of knowledge and how we work with clients.

    In my opinion, your first and second points should be viewed independently, however. The active/passive arguments carry too much baggage to roll into this discussion. We’ll get nowhere but back to the same bickering that is far too common.

    Anyway, great question raised. I think it deserves some real exploring.

    • Michael Kitces

      The two are inextricably linked.

      Only in our strange world do we acknowledge research that clearly shows our clients are more adversely impacted by declines than they are by comparable rises, yet insist that the greatest “risk” our clients face is FAILING TO ENJOY A BULL MARKET.

      If we REALLY believe what the research clearly states, why isn’t the default “avoid losses at all costs, and just try to make a little gain when you can”?

      Don’t answer based on “what we’ve all been taught” as an industry. Answer what a normal, emotional human being would answer… and then it becomes increasingly clear why we are so disconnected from the public!

      We’ve all insistently told each other for so long that “you can’t possibly know when markets will underperform” that we insist on refusing to NOT look at data that BLATANTLY show the statement to be false.

      – Michael

      • Nathan Gehring

        I don’t disagree in any way that the two points are very closely linked. The second is clearly an extension of the obvious answer to the first.

        Unfortunately, “what we’ve all been taught” gets in the way of having a meaningful discussion. The “what we’ve all been taught” needs to be addressed on its own merits so that we can move beyond those biases.

        But it would be a mistake IMO to ignore your first question as a profession while we wait for the second to be resolved.

        They can both be explored at the same time. But I don’t think they can both be explored together at this time.

        • Michael Kitces

          I don’t know how we address the question “is it ever right to work with our clients’ loss aversion concerns and more actively defend them against losses” if we’re not willing to acknowledge that “being more active” is part of the discussion.

          We’ve so convinced ourselves that it can “never” be right to take active steps to protect clients that we’ve literally convinced ourselves the ONLY possible answer is “stay the course” and ride it out – despite the clear mental anguish that inflicts on clients.

          I wouldn’t even know how we COULD address loss aversion issues for clients if we’re going to insist on a framework that says “let’s come up with loss aversion strategies only in a world where clients always stay fully invested with no portfolio changes.”
          – Michael

        • Nathan Gehring

          Yes, we’ll have to get to that discussion. But does it need to be done immediately? I think not. It just requires a simple reframing to ask the same loss aversion question.

          Instead of considering the role of loss aversion in portfolio management and thereby conjuring all the biases implicit in that discussion; consider the role of loss aversion in a different context.

          For example, how would we advise loss averse clients in taking risky tax positions? They have the choice of taking a position that has merit and could pay off with significant tax savings. But the position is also reportable and could result in major penalties. Do we account for a client’s loss aversion here?

          The question can be reframed into any risk:reward context. The loss aversion question is equally valid in all contexts of the financial planning process. There’s no need to begin with the most difficult place.

          The active/passive cluster____ can be avoided initially. Besides, answer the loss aversion question and there’s a natural conclusion that has to be drawn in investment context.

          • Michael Kitces

            But Nathan, the point isn’t abstractly to say “Hey, clients are loss averse.” The point, very specifically, is that we do not INVEST for clients in a manner consistent with loss aversion tendencies.

            We have no trouble with it in other contexts. We push the importance of insurance because of the loss consequences. We push conservatism in tax planning because of the averse loss consequences of audits and disallowed deductions.

            It’s just in the investment realm that we seem to diverge. That’s the point of the conversation.

            – Michael

          • Andrew Head

            There are some very interesting points being made here and I am glad to see the discussion coming alive again. Nathan and Michael have had me thinking about this some more.

            You are both correct that the active/passive discussion married to main point of the discussion, as I commented about further above. I also think it is somewhat premature as Nathan suggested, but not for the reason described.

            What I think this ultimately comes down to is that part of the job and duty of a planner is to what is “best” for the client. That is a very, very simple statement, but in reality a very, very complicated one.

            I feel that calling it silly that we say that the biggest risk our clients face is “missing out on a bull market” is an oversimplification and potential straw man. Of course that SOUNDS ridiculous, but in reality it is the biggest risk of all. Yes, clients perceive downside risk with a much higher sensitivity than any other risk. It is very tempting to allow that sensitivity to dictate a portfolio strategy but the real job of the planner is to point out the error in that line of thinking. Over-sensitivity to losses leads to the biggest risk they are exposed to: underweighting equities to the point that they are now unlikely to meet their long term goals and even underperform inflation.

            I don’t use equities because I am insensitive to the loss aversion issue, it is just that I attach a much higher importance to making sure I have the best chance of meeting long term goals for income, etc and make sure they truly understand why I am managing their money the way that I am. And we all know that is often a case of trying to force as much blood from a stone that we can with a portfolio because the client didn’t do nearly enough saving before we got to them.

          • Michael Kitces

            You say “missing out on the bull market” is an oversimplification and straw man, yet you follow that by making my point in saying it IS the greatest risk.

            WHY!? Why are equities the ONLY solution on the planet to have a successful retirement? Baby boomers are virtually the first generation to EVER even TRY to rely on equities. Their parents’ generation didn’t; they enjoyed their retirements largely equity-free, thanks to the scars of the Great Depression. But they survived. They did it.

            Is it because equities “always” outperform? Except for the past 10 years? Except for the entire 30-year period from 1979-2009? How long does our advice have to be wrong before we admit it might be wrong?

            A client who underweighted equities 15 years ago is RADICALLY closer to retirement than a client who held onto their equity exposure. That is a fact of the market returns. When will we be willing to acknowledge that our advice might need adjusting?
            – Michael

          • Deon

            I want to send you an award for most helpful itnenret writer.

  • John Prendergast

    Love the discussion here. The thing that strikes me as a little curious is the focus on client feelings. Loss aversion in the literature you refer to (and in life) is an *observable behavioral phenomenon* but much of the first part of the argument is around clients feelings. Essentially, “why do we do this if it makes them feel bad?”

    I appreciate that is both because feelings drive behavior and because we’re in the business of guiding people. However, feelings don’t always lead to action and unless they do, those feelings have no investing consequences. To be sure, the feelings have relationship consequences and that is critical. Managing client emotions is an important topic. It’s just not the same as direct investing consequences. It seems that the right strategy is one that the client can execute both financially and emotionally not necessarily the one the makes them feel best.

    That said, I agree that the standard advice of “stay the course” is insufficient. However, it can work very well if it’s also paired with a strategy of taking on only as much risk as necessary to reach a client’s goals. I think that’s essentially what you’re arguing for toward the end and I couldn’t agree more. It would be a different world indeed for clients and advisors both.

Michael E. Kitces

I write about financial planning strategies and practice management ideas, and have created several businesses to help people implement them.

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