Expert attributes investor failures to flawed thinking

Sep 19, 2005 @ 12:01 am

By Dan Jamieson

IRVINE, Calif. - In 1896, when the Dow Jones Industrial Average began, the index stood at 41. The Dow tracks only appreciation, so here's a question: What would its value be today if dividends had been reinvested?

That question was posed to 50 financial advisers at a meeting here last week of the Southern California chapter of the Denver-based Investment Management Consultants Association.

The questioner was Meir Statman, a prominent academician in the field of behavioral finance, who spoke at the meeting.

Most of the advisers guessed that with reinvested dividends over that long time period, the Dow would be higher by a factor of 10 or 20, maybe to the 100,000 or 200,000 level.

Wrong, said Mr. Statman, a professor of finance at Santa Clara (Calif.) University. Reinvested dividends would have brought the Dow up to more than 900,000.

This example illustrated the cognitive bias of "anchoring," or getting hung up by past values of an asset or index, Mr. Statman said.

Hard-wired for failure

Cognitive flaws such as this cause investors to make all sorts of mistakes.

Mr. Statman went through a long list: Investors tend to take profits too soon and keep losers too long. They irrationally remember what an asset was worth at some arbitrary peak. They're overconfident in their abilities to pick stocks or time the market.

People have illogical regrets about past financial decisions. And, of course, a certain number of them take credit for winners and blame their advisers for all the losers.

That last observation drew nods of agreement from advisers.

While acknowledging that some of these impossibly difficult clients should be dumped, Mr. Statman said that blaming others is natural human behavior and can be dealt with by educating investors about behavioral flaws.

"Make science your ally," he said.

The field of behavioral finance seeks to develop theories that will help deal with flawed, but normal, human behavior, Mr. Statman said. In behavioral finance theory, investors are motivated by achieving goals, not avoiding unnecessary risk, which is the premise of modern portfolio theory.

An optimized portfolio, Mr. Statman said, is nothing more than a "bundle of risk and return," which doesn't do anything by itself to motivate clients. He said it is better to segment the portfolio by distinct goals, such as retirement, college and charitable giving, and then run separate Monte Carlo simulations on each piece.

Having enough for retirement might warrant a high probability of success, while charitable giving might be less important.

"For some goals, having the money is really important, for others, not so much," Mr. Statman said.

"Better brokers have intuitively understood behavioral finance all along," said one wirehouse rep who attended the meeting and asked that his name and firm not be used. Clients need to understand that their adviser has technical proficiency, this rep said, "but it always comes down to the relationship," and that's where behavioral finance theory can help, he said.

'Temperament sorter'

One online tool brokers can use to improve communication with clients is advisor.com, which has a "temperament sorter" that categorizes people by behavioral styles.

Mr. Statman said advisers can test both themselves and willing clients.

Steve Schoen, president of Allied Consulting Group in Los Angeles and acting treasurer of the Southern California IMCA chapter, said that last week's event brought in 60 members.

Unlike other chapters, it is funding its activities without the help of sponsors.

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