As advisors we are accountable for the results that we deliver to our clients. Those results can be measured in different ways: did we generate the return that was needed by the client, did we adequately save enough for retirement or to send little Johnny to college. Each client has a different result that we must be aware of and strive to achieve.
So what prevents those results from being achieved?
In order to generate a result we have to take some action. It could be financial planning, portfolio construction, analyzing a company, hope and prayer. All are actions that will lead to a result.
But why do individuals have such a broad array of results – perhaps it’s because we are human. Each person is different – whether it is genetic or environmental, every One of the fundamental assumptions behind Modern Portfolio Theory (MPT) is that all investors are rational and risk adverse… (Background Information on MPT). No need to comment any further.
If all investors cannot be considered rational, then what drives their behavior? A lot of work has been done in recent years on the field of behavioral finance – the 2002 Nobel Prize in Economics was awarded to two Psychologists, Daniel Kahneman and Amos Tversky for their pioneering work in the field of prospect theory. Much has been written (Books on Behavioral Finance) on the field of Behavioral Finance and Neuro-Finance over the recent years – a great presentation can be seen here (Presentation).
Not only is it important to understand the bias of the investor but it is equally important to understand the beliefs of the advisor – do they seek out information to strengthen their point of view or do they seek to have their point of view challenged. It is important to understand what can go wrong with a model or investment.
We live in some of the most financially stressful times in history both within the capital markets and also people’s lives. Debt and entitlements are raging out of control and have created a global economic situation that will influence the investment results that investor’s will experience.
With an understanding of how we make decisions, it may lead us towards the path of achieving our client’s results.
I have put together a brief graphic that can help us remember and understand the relationships between our results and beliefs. If we are aware of how beliefs and behavior effect our actions – then perhaps we can generate the results that people want and need.