It’s nearly impossible for an investor to remove emotion from the decision-making process, according to a professor of finance.
Research has shown that people make financial decisions in the limbic system of the brain, which is where emotions reside, said Lisa Kramer, a professor of finance with the University of Toronto Mississauga.
“We can’t say, ‘If you weren’t acting so emotionally, you would be able to make better financial decisions,'” she told attendees at the Investments and Wealth Forum in Toronto on Monday. “Everything we do, including financial decisions, requires emotions as an impetus. So we can’t ignore what’s going on in this deep region of our brain.”
This makes the role of an advisor — someone who can provide an objective, third-party perspective — that much more important. Similar to advisors managing a client’s risk, they may need to manage their emotions, Kramer said.
One example of emotions governing investment decisions is the correlations between seasonal affective disorder, investor behaviour and market performance — a phenomenon Kramer and her colleagues have studied for more than 20 years.
Kramer highlighted that traditionally, September and October are poorer-performing months for the market. The S&P 500 has seen a September decline of 7% or more 11 times going back to 1928, according to MarketWatch. While Octobers have performed better than Septembers, significant market crashes, like in 2008, 1987 and 1929, have occurred in October.
Both months are when days begin to shorten in the northern hemisphere, which can dampen moods among the general population. “We all just feel a little more despondent,” Kramer said. “The more depressed a person is, the more averse they are to risk, including financial risk.”
Kramer said her research has found that the riskiest categories of U.S. mutual funds tend to see large outflows during the fall and winter, when many investors experience increased risk aversion.
Conversely, she has found there tend to be large flows into the safest categories during these times.
Advisors who know about this tendency can educate their clients and help them avoid it.
“If investors act according to their emotions, if they sell risky assets in the fall and buy them back in the spring, they’re going to end up worse off. They’re leaving a lot of money on the table,” she said. “[You] don’t want people making investment decisions that is responsive to strong emotional urges.”
John Nersesian, head of advisor education with PIMCO, said during another session at the forum that advisors can help manage clients’ emotions by presenting them with historical data and evidence about how tumultuous markets in the past occurred and how investors who stayed invested rode the recovery wave.
Advisors should also show empathy to their clients, he said. As an example, advisors should consider revisiting the common phrase “stay the course.”
While advisors mean clients should remain invested and take a long-term approach, clients may interpret the phrase differently, Nersesian said.
After hearing the phrase, they may think: “I’m telling my advisor I’m in real pain right now. My portfolio is getting killed. Everything I’m reading suggests this may continue. My advisor doesn’t hear me; my advisor is hearing me, but they don’t care; [or] my advisor doesn’t have anything better to offer me.”
Nersesian suggested that instead of telling clients to “stay the course,” advisors can reiterate and clarify their clients’ concerns, tell the client they will examine potential options and reconnect with them in a week to discuss the best action plan.