Super Bowl 52 was nothing short of spectacular. The New England Patriots, stacked with Tom Brady and Bill Belichick, looking to win a sixth Super Bowl and make history in front of our eyes … against the Philadelphia Eagles. Phila-who?
The underdog won. The Eagles victory seems almost unreal. However, if you look deeply into the history of football and the NFL record books over the past 23 years, whenever the spread is tight, the underdogs are the more likely victor.
In fact, according to NFL records, the underdogs won outright in almost 70% of all games where the spread was under seven points. (Suggested reading: "David and Goliath: Underdogs, Misfits, and the Art of Battling Giants," a Malcom Gladwell best-seller that captures why the improbable is not what it seems.)
In behavioral terms, NFL spectators were confident the New England Patriots would beat Philadelphia because they were under the influence of recency bias. Most picked the Patriots to win the big game based on evidence that lined up with recent events: Tom Brady is a winner, Bill Belichick rarely loses the big game, teams wearing white uniforms more often win the Super Bowl, the Patriots collected last year's Lombardi Trophy in a thriller, and they have five NFL Championships. Armed with compelling recent data, it was hard to think the Eagles had chance. Considering the data, our brains would not let us accept anything but a Patriots win.
In financial terms, recency bias is real and is best defined as investors' tendency to evaluate their portfolio performance based on recent results. This bias (or lens) has a large impact on clients' emotions when they witness events that don't line up with recent experiences. In fact, the evidence suggests that many clients have already extrapolated market returns for 2018 based on the results in 2017.
Who can blame them? In 2017, Mr. Market posted positive gains every month, the volatility of the market was the lowest in years, and year-end returns in every sector were in double digits.
As we round out the first quarter of 2018, clients are forced to grapple with more normal levels of market volatility. (It's so different from 2017 that the human brain wants to fall out on the floor.) Any internal discomfort that clients feel today is real — and it's triggered by emotions that are left over from 2017. Welcome to recency bias.
Now, let's layer on another very real cognitive phenomena: impact bias. Impact bias is our tendency to overestimate the length or intensity of a future set of events. When we fear something bad will happen, we magnify it. When investment markets behave poorly, we instantly consider the worst possible outcome and anchor our emotions around the length of time that will last and the amount of pain we will feel.
Most humans immediately recall, say, the market crash of 2008, and we fabricate stories that include the pain of personal loss. Most of the time, however, the pain doesn't match the reality. It's just our brain's self-destructive behavior at work, thinking it is defending us.
Managing client emotions is real stuff. The two biases combined (recency bias plus impact bias) can lead to client issues if left unattended.
Behavioral scientists have long studied why investors make costly mistakes that undermine their long-term goals (e.g., Barber and Odean 2000, Shefrin 2007, Thaler 2005, Baker and Ricciardi 2014), and when we overlay the top 12 emotions connected to the market's natural flow, as in the diagram below, we begin to see why our clients are such complex creatures.
The impact Mr. Market can have on your clients is very real, so knowing what can trigger their negative emotions or false fears is important to the overall advice process. Advisers must work with clients to overcome inherent cognitive biases if the financial plan is to work long term.
Here are three techniques behavioral finance experts suggest can help limit the irrational panic that appears when client biases show up:
1. Help them avoid frequent price updates as this leads to perceptions of risk and volatility. Homeowners don't check the real estate market every day, although it too fluctuates based on buyer demand. Why should clients view their retirement portfolio or investment plan any differently? A quarterly check will smooth out their perception of gains and losses and remove emotion.
2. Refer to the written financial plan or the investment policy statement from time to time as a reminder of the client's diversified portfolio and the approach your firm has for each client. This refresher step has been shown to help clients understand their managed risks and the motivations behind the advice.
3. Help clients ignore the voice inside urging them to chase returns or try to adjust the investment plan when impact bias and recency bias are at play. These biases can wreak havoc on a plan's rationale and often lead to poor decisions that hurt long term. Manage the friction with an open dialogue before any action is taken.
Remember, if your clients feel any of these biases sneaking up on them during times of market volatility, take solace in knowing that they are human. The brain doesn't know what is doing — but you do!
May your quality advice show up in irrational times.
Jim DeCarlo is chief executive officer of StratWealth.