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If you want to get into the wealth management business, here’s some very good news.  You don’t need to know much about managing wealth.  In most cases, these practitioners simply find the money (i.e. get the clients) and then hand their money off to third party money managers who pick the stocks and bonds.  So if you want to be a wealth manager, all you need to know is how to prospect (i.e. get clients), create and maintain relationships. (note that our sister web site www.registered-investment-advisor.com explains the process to get a certificate, in effect a license, to charge fees for managing investment accounts).

One of the best places to start is to read this article and then give a copy to your prospects. You will then be one of the better wealth managers around because being a great wealth manager is about managing psyches and relationships, not about managing wealth.

Why Investors Fail

My apologies to the high-IQ investors out there, but when it comes to investing, smarts don’t matter.  Whether an investor is intellectually gifted or below the norm is irrelevant, as plenty of Ph.Ds have lost money in the market. What matters are your emotions and the actions you take as a result of those emotions.  What you read below are the results of studies with real live investors, like yourself, and how they behave with their investments.

It is imperative to realize that you are at the mercy of your emotional reactions, and you don’t even know it. The field of Behavioral Finance studies and explains how emotions and cognitive errors influence investors and the decision-making process. Here is a sampling of what behavioral finance studies have found so that you can hopefully notice these tendencies before you are afflicted.

Investors suffer from overconfidence.
You might even think of yourself as timid, but in their book, Why Smart People Make Big Money Mistakes, Gary Belsky and Thomas Gilovich  provide evidence that simply by believing he can actively manage an investment portfolio, an individual who is not professionally occupied in the financial services industry (and some who are), probably suffer from overconfidence. Further, they reason that the problem of overconfidence should end at the point at which it leads to a significant loss. But actually, the opposite is true. When people make a mistake, they blame it on someone or something other than themselves.

Harvard psychologist Eileen Langer explains that when events occur that confirm the correctness of one’s actions, the individual is highly likely to attribute the occurrence to his own ability. On the other hand, when events do not fall in one’s favor, proving perhaps that the individual has been wrong or mistaken, he is most likely to attribute these occurrences to events out of his control.

Investors are overly optimistic.
Optimists exaggerate their own abilities and underestimate the likelihood of negative outcomes over which they have no control. Instead, they tend to exaggerate the degree to which they control their fate. Take this example of car drivers: When asked the following — As compared to other drivers you encounter would you say your driving abilities are average, above average, or below average?  — 80% of the responders answered above average. It would be nice if this were the case, but surely many of these drivers are overestimating their driving skills based on my drive to work today.

Another way to view optimism is to look at what behavioral economists call the “planning fallacy.” Belsky and Gilovich offer an example in which Montreal was selected to host the 1976 Summer Olympics. The mayor had announced that the entire cost would total approximately $120 million and that track and field events would take place in a stadium with a first-of-its-kind retractable roof. While the games went off without a hitch that summer, the roof was not implemented until 1989 and ended up costing $120 million alone, almost as much as was budgeted for the entire Olympics.

In their study, Capital Budgeting in the Presence of Managerial Overconfidence and Optimism, Simon Gervais, J.B. Heaton and Terrance Odean found that optimism is most severe among more intelligent individuals. It would seem the smarter you are, the more confidence you have in your ability, which, in terms of the stock market, can cost you a fortune.

Hindsight is 20/20.
Within hours of the market’s close, “experts” will appear on television or speak on the radio with great confidence as to why the market acted as it did. Seemingly they give the impression that such actions were so obvious that they could have been predicted beforehand. But the truth is, if an event had been predictable, it would have been predicted causing the actions of many to prevent it from happening in the first place. Robert J. Shiller, a professor of economics at Yale University, found that at the peak of the Japanese market, 14% of Japanese investors expected a crash. After the crash, the number of investors who said they’d expected the crash more than doubled, reaching 32%.
Investor hindsight can be troublesome when in hindsight an investor sees what was a reasonable investment as a foolish gamble and then he blames his advisor.   And after what seems to be an inevitable drop in the value of a stock, he will wonder why his advisor did not suggest selling it earlier. Hindsight can lead to advisor scapegoating. Still, if that stock had seen a gain the investor would more likely congratulate himself for the investment decision.
Finding patterns and correlations where none exist.

It is a human instinct to seek patterns, i.e. familiarity, in a random series of events. This all-too-human characteristic can be disastrous in the world of investing. What typically occurs is that investors attribute much more meaning to an event because of those that precede it. This leads investors to perceive trends where none exist and to overreact and take action as a result of these false perceptions.

For example, how many times have you heard the following sort of generalizations from your friends:
“When the Republicans are in office, the market goes up/down” (fact is, the record of both parties is about even). Or, “The Stock Market always rises in election years” (you need only look at the most recent election year to find the error in this statement, the stock market was down 9.1% in 2000). It’s human nature to look for and fabricate patterns and truisms when none are there. It’s a natural yearning to make sense out of non-sense.

Investors Lose by Not Taking Losses Quickly.
How many times have you thought, “But it’s a good company, it will go back up.”
A study by Terrance Odean of the University of California at Davis, argues that investors are quicker to realize their gains than their losses. Odean analyzed the daily trading records and monthly positions of 88,000 investors at a large discount brokerage. The data spans 10 years and over 2 million common stock trades. Investors in his study traded too actively, were under diversified, clung to their losers, and bought stocks that happened to grab their attention. They were also overconfident and motivated by the desire to avoid regret. The difficulty in the evaluation of thousands of investment alternatives also contributed to their poor trade results. One of Odean’s findings was that investors were much more likely to hold on to losers and sell winners.

The investors in Odean’s study were those who disregarded or didn’t believe in the value of a financial advisor. They thought they could do it on their own. Odean’s study proves that the surer they are, the worse they do: 20% of the investors who traded most often earned an average net annual return 5.5% lower than that of the 20% least active traders.

Prospect Theory, originally described by Daniel Kahneman and Amos Tversky, says that individuals are much more upset by prospective losses than they are cheered by equivalent gains. Therefore, the loss of $1.00 would be twice as painful as the pleasure received from a $1.00 gain. Researchers have also found that people are willing to take more risk to avoid losses than to realize gains. In other words, when faced with sure gain investors are more likely to be risk-averse, while when faced with sure loss, they turn into risk-takers.   Just think how this pattern could affect the average investor. One bad investment decision will threaten him with a sure loss, which will lead him to take more risks in order to avoid this loss.

Familiarity and locality.
Individuals place too much emphasis on what is familiar to them, and as Belsky and Gilovich point out in their book, “The problem with the idea that you should ‘invest in what you know’ is that people over-confidently confuse familiarity with knowledge.” Gur Huberman of Columbia University has found that investors favor investing in local companies with which they are familiar. Huberman found that there were no rational reasons behind these investments other than the comfort familiarity brought to the investor.   The companies in your area are no better or worse than those in any other area.  Just ask Californians who fell in love with technology stocks.

Herd mentality.
Investors are particularly susceptible to herd mentality. This is true for a number of reasons. Investors will follow the herd to avoid the possible feelings of regret should their decisions prove incorrect. An individual will find it easier to rationalize a loss on a popular stock than a loss on an unpopular stock. During times of uncertainty when one does not know how to behave, the fact that many others are following a certain plan is a compelling reason to mimic them. The higher the stakes, and the larger the uncertainty, the more likely an investor is to go with the flow.
For example, Money Magazine compared the reported fund results of five funds over a one year period (December 31, 1995 to December 31, 1996) to the average investor results as measured by actual investor accounts in these funds during this period.

The shareholders average return was minus 15.08%. The funds’ average was 22.94%. The difference in results comes from the fact that the average investor invests once the fund has already risen in price and gets out after the fund declines.

A contributing factor to herd mentality and investor overreaction is the inordinate amount of financial news available. Investors who rely heavily on financial news stories for advice aren’t necessarily any better off, and in most cases they fare worse than those who ignore news stories altogether. Belsky and Gilovich recommend that investors avoid “hot” investments and tell them that they are, “… probably better off disregarding most financial news.”
Have you seen yourself in any of the above examples? If you’re ready to give up—wait—there’s an answer. Experienced financial advisors know about these problems and can act to keep you from committing these financial “sins.” Winning at investing is less important than avoiding mistakes resulting in financial loss. Use an advisor and let those other people make the mistakes.

My recommendation is that you give your funds to a portfolio manager, nowadays called wealth managers.  Your own emotions and money just don’t mix. Visit www.retirement-income.net/blog for current posts on managing money in retirement.