Saving clients from the emotional roller-coaster

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The G.I. Joe cartoon from the 1980s is fondly remembered by those of a certain age as much for its public service announcements as for the series itself. The show’s characters taught kids not to swim in a thunderstorm, or what to do if their clothes caught fire. Each episode ended with the chastened kid saying, “Now I know.” To which the show’s character responded: “And knowing is half the battle.”

The PSAs spawned a parody series but also, more surprisingly, a place in the behavioural finance lexicon: “the G.I. Joe fallacy.” As Coreen Sol explains in her latest book, Unbiased Investor: Reduce Financial Stress and Keep More of Your Money (Wiley & Sons), knowing is not half the battle.

“We get this false sense of comfort that we’re going to behave in a certain way going forward because of new knowledge,” said Sol, senior portfolio manager with CIBC Private Wealth in Vancouver. “And yet, we can’t apply it unless we put specific steps in place.”

Sol, who manages $250 million for small institutional accounts and high-net-worth families, discussed the biases investors are up against and the processes advisors can develop to insulate clients from poor decisions. This interview has been edited for length and style.

AE: In the book, you group investor biases into three categories. What are they?

Coreen Sol: There’s a laundry list of biases: hindsight, anchoring, representativeness and all these terms that aren’t that practical. I started playing with them and realized there’s three main underlying motivations.

The first one is making sense of what you see: organizing the world, looking at how we categorize things, how we process information, and how we understand our environment.

The second is how we try to control risk — and it’s often at the worst possible moment.

And the last one is that lovely predisposition to want to be right. We have this bizarre focus on trying to justify ourselves … and a lot of biases come into that process.

AE: Of the three, is there one group that you see the most in your practice?

CS: I think one of the biggest issues is how we try to control risk. We like to think risk is a relatively stable characteristic, but risk literally depends on what happened to you last. Your risk tolerance will be directly influenced by the last transaction you made: how successful it was (or unsuccessful); whether you created or lost wealth. And it will have a direct impact on your outlook.

Here’s an example: you go to Vegas, you slap down some money at the blackjack table, you take your original money off the table, tuck it in your pocket and you let the winnings ride. Most people will take higher risks with quick earnings. That’s the “house money effect.” It’s not really your money, you don’t really identify with it. Yet it is your money, and it can pay for your mortgage, it can buy you a can of soup. But this dissociation from the winnings allows us to take risks we normally wouldn’t take.

That’s an easy example, but “once bitten, twice shy” tells you what you need to know about risk aversion. Your risk tolerance is directly related to what happened to you last.

AE: There was a paper a couple years ago about an experiment around horror movies. People who were shown a clip from a horror movie and then asked to make investment decisions were way more cautious. You don’t know what a client did before coming into your office. I know you’re talking about your last investment decision, but it seems like it could even be something more immediate.

CS: Yeah, say you’re crossing the street as you’re coming into the office and you almost get hit by a car. There are a lot of biases that interrelate there, such as recency effect, risk aversion — which is why I wanted to do that categorization.

AE: One of the practical ways to avoid bias is to establish what you call “personal economic values.” What are these?

CS: The obvious way to reduce bias is to make fewer decisions. How do you make fewer decisions? Well, you make better decisions. And you make better decisions when you know who you are, your underlying values, your objectives, your shortcomings and your fabric. If you spend some time to build that fabric, then you can make long-term decisions when things are calm, when you’re not influenced by what just happened. If you can base decisions on your personal economic values … you can keep your eye on the horizon, rather than being caught up in transactional, in-the-moment decisions.

AE: What other habits can advisors encourage clients to develop?

CS: An investment policy statement is a must — just having that basic outline for your goals and objectives. And stop checking your investments. Because when you do, it generates all kinds of opportunity for interpretation, errors, transactions, panic, doubt [and] anxiety. And the more often you make a transaction, the higher your risk is for errors.

AE: What is the most important skill or characteristic that advisors offer clients?

CS: They have the time and resources to overcome lots of these biases. They have the step-by-step documentation process. They have a decision-basis log. Plus, their experience and their education help control status quo bias, for example.

Status quo bias and loss aversion work hand in hand when markets are volatile. When markets are going up, people feel comfortable making investment decisions. People do a lot more trading. When it’s contracting, lots of people say, “I’m just going to hold on until it recovers.” And then they leave the first 20% of a rebound on the table.

As a professional you also have better objectivity because there’s an arms-length relationship. You’re not caught up in the emotional roller-coaster.

AE: We saw a lot of direct investing accounts open over the last two or three years, and a lot of trading activity. You assume some of those people aren’t feeling quite as good now as they were back in 2021. What case can advisors make to DIY investors that their services are needed?

CS: The expertise and ability to apply time and resources to a disciplined process is huge. Portfolio abandonment is a big problem for self-directed investors.

Just knowing how things behave in the real world is a really important aspect of what professionals do. Half of the job is keeping the clients on the train, knowing that the train’s getting to the station. You can intervene when all of these other aspects come up — these biases and changes in risk tolerance and so on.