Key to Protecting Client Assets: Understanding the Human Nature of Irrational Decisions

Tough times do not last, tough people do. At first, this quote may sound irrelevant to the title given above but, making clients understand that this too shall pass is sometimes difficult. Ask yourself, how many times have you allowed your emotions to rule in critical circumstances? Especially while looking at the current market scenario, the strongest of the investors might feel skeptical if you ask for investment solutions.

It is natural. When it comes to investment decision making, our emotions take over; the reason is human psychology behind it. We feel the pain of a loss to a greater extent compared to experiencing the joy of gaining. If you have observed, the emotional impact of loss is higher than of the equivalent gain – and it is called Prospect Theory or ‘loss-aversion’ theory.

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Understand this with a simple example: in a situation, you are receiving $40 as an amount of utility, and in another situation, you gain $80 and then lose $40, so the remaining amount is $40 again. Here, the net gain is $40 but, the second situation disappoints you. According to this Prospect Theory, an investor tends to hold onto a losing stock longer than he should and sells winning stocks sooner than he should.

The fundamental logic would be holding onto winning stocks in order to boost the gains and selling of the losing stock in order to prevent the soaring losses. There is a sufficient number of analytical studies done on investment management. One study shows that when it is about selling winning stocks prematurely, people often settle for a lower guaranteed gain of $50 than a riskier yet higher gain of $500 or nothing. It is a matter of loss and gain or if put aptly, loss, and guaranteed gain.

For any financial adviser, it is essential to understand the human nature of making irrational decisions. It prevents you from being a victim or helps you to save your clients from doing the same. For further explanation, let’s take two quotes from William J. O’Neil’s How to Make Money in Stocks: A winning system in good times and bad.

  1. “A great trader once noted there are only two emotions in the market: hope and fear. The only problem is we hope when we should fear, and we fear when we should hope”. To avoid emotional decisions in investments, one can implement a relative strength system. It is a calculation that happens by the division of security price in routine, and it comes in life by plotting it on PnF (Point and Figure) chart. There is no grey line in the chart, it is either on buy signal or on sell signal. This permits you to construct a relative portfolio conducted in a consistent and sensible manner based on the strength system, which further helps you to make the right decisions. 
  2. “The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong.” Believe it; psychology often gets in the way of making reasonable decisions in unfavorable times. However, if you succeed in conveying the above quote to your client, you are playing a vital role in their asset management. 

    Furthermore, research by James O’Shaughnessy helps to establish credibility for the process. He tested everything from P/E ratios and price-to-cash flow ratios to market capitalization, profit margins, and relative strength. The research was conducted over a span from 1951 to 1996 where he examined things separately as well as with joint variables. The summary included one common factor in the top 10 performing strategies, and that was relative strength.Daniel Kahneman, a Nobel Prize winner in Economic Science, put an appropriate example in his speech. An investor notices the increase in his portfolio from $1 million to $1.5 million, whereas the other investor sees the fall to $2 million from $3 million. Who is happier? Sometimes, it is imperative for your clients to focus on the guaranteed least loss rather than a riskier gain. If a good strategy is working so far and suddenly shakes, it’s the timing to blame and not the strategy.

Keeping emotions on the check is challenging sometimes or rather often because several factors affect the stock market. It is difficult to spend energy on patience, which brings rational decisions as the brain is coping with multiple challenges. A right adviser uses the best of the knowledge to keep clients safe from loss and assists them in making the right decision in the tough times.

Interested in knowing how to protect your assets? We would love to have a word with you.

Written by:
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Prashanth Prabhu, Founder & Principal Investment Adviser – 29k Group

Published by:

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Sheren Susairaj, Marketing Associate – 29k Investment Advisers Pvt. Ltd

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