Why Having A Financial Advisor Helps

Behavioral Finance, that’s why!  There are two types of investors:  rational and irrational.  Which one are you?  The odds are that you are more irrational than you think!  What?  Yes, that’s correct, and rational investing is an area where having a Financial Advisor can add value.

The last year or so has drawn a lot of attention to artificial intelligence (AI).  It is rational to learn about AI to identify investing opportunities to gain exposure to a higher growth area of the global economy.  It is irrational to invest in any and all companies that mention AI just because they mention AI.  Tread lightly.

Daniel Kahneman, a renowned psychologist, won the Nobel prize in economics because his work challenged the view that we can model people as essentially rational.[1] His work revealed that investors will often deviate from rational behavior due to bias and those deviations adversely impact investing performance. This launched the field of behavioral finance, which highlights the traps into which investors can fall and, thus, the value of a financial advisor.

So, what are the “traps”?

Trading just to trade

• Rational investors trade when money is deposited or withdrawn, for tax management, or when new information triggers a need to rebalance.  Irrational investors tend to become overconfident in the stories they tell themselves about the world, and also about companies and their potential for greatness (or decline). They sell some stocks and buy others, because they are convinced that the latter will outperform the former. Many studies show, however, that retail traders trade on too many ideas and are wrong, on average, about the stocks they buy versus the stocks they sell. And not by a small amount: over a one-year horizon, the average return on the all the stocks bought is 3.3% lower than the stocks sold, and when looking at the stocks they buy shortly after a sale, those purchased underperform those sold by 5.82% after one year.[2] That’s a huge difference!  Imagine how that could impact a portfolio over a lifetime.

Short-term versus Long-term

• Rational investors focus on the long-term.  The gain or loss is irrelevant.  Irrational investors tend to focus more on short-term gains or losses.  They also find losses more emotional than gains of the same size.

Cost Basis versus Growth Potential

• Irrational investors are more likely to sell stocks that are up relative to cost basis, rather than down, because they see the former as showing they have succeeded, while selling the down stocks makes them feel that they are failures. This runs counter to the rational investing strategy: not selling a stock based on a price relative to its cost basis but based on the stock’s potential going forward.

Personal Experience versus Data

• Irrational investors tend to extrapolate erroneously from personal experience to validate their judgments of a stock, an industry, or a company, and those extrapolations are unlikely to match the true characteristics in the data.

These cases irrationally lead investors away from taking a full portfolio view and direct them to focus too much on individual stocks, worrying overly when one falls, and celebrating too much when one rises. Research in behavioral finance shows that such biases lead to underperformance.

Professional investors, by contrast, appreciate the role of diversification in a portfolio, are incentivized to optimize whole portfolio performance, take a rigorous approach to assessing risk, and recognize that “you win some, you lose some” when it comes to individual stocks.  The professional investor develops an investing “policy” for clients rather than making one-off, short-term decisions, and this approach helps to counter the very human biases that behavioral economists revealed.

At Virtus Wealth Management, we understand behavior finance, partner with our clients to overcome bias, and use a rational investment approach to help them pursue their goals.  Let us help you escape the traps of the irrational investor and do the same!

[1] Economists know people are not rational, but that modeling construct can still yield powerful insights for all sorts of economic questions, such as saving vs consumption and working vs leisure. But when there are systematic biases, such as Kahneman found in attitudes towards risk, then the model’s insights can steer us to the wrong conclusions.

[2] Odean, Terrance, 1999, “Do Investors Trade Too Much?” American Economic Review, 89(5): 1279-1298. Other studies showed similar effects of excessive trading.