TEXT ON SCREEN: PIMCO
TEXT ON SCREEN:PIMCO EDUCATION –TITLE – Using Behavioral Finance to Reach Client’s Goals with John Nersesian
TEXT ON SCREEN: John Nersesian, Head of Advisor Education
TEXT ON SCREEN: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. The information presented in this video is intended for educational use with investment professionals only. Some references may be region specific, dated or not applicable for all viewers. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation.
Nersesian: Hi. I'm John Nersesian. As a former financial advisor, I believed that my primary job was to manage client capital. But there's something critically important, equally important, that we manage as well for our clients, and that is their emotions, their behaviors, their decision-making, in an attempt to allow them to achieve the very important financial goals that they've identified.
Let's get into the topic.
TEXT ON SCREEN: TITLE – Agenda
IMAGE ON SCREEN: Three items are listed side by side, each in a box. The first box, on the left, is labeled “Introduction to behavioral finance.” The second box highlights “Common biases,” and the third, “Strategies to mitigate behavioral biases.”
Here's our agenda for today. We're going to spend a few minutes discussing or defining behavioral finance. We'll then identify some of the more common biases affecting both investors and advisors, and then finally we'll conclude our discussion by identifying some of the best practices being used by leading financial advisors to help mitigate the impact of these biases on investor choice.
TEXT ON SCREEN: TITLE – Introduction to behavioral finance
So, what is behavioral finance? What do we mean by that terminology, and maybe just as importantly, why is it relevant?
TEXT ON SCREEN: TITLE – Defining behavioral finance; SUBTITLE – Introduction to behavioral finance
IMAGE ON SCREEN: Three boxes side by side explain behavioral finance. The first, on the left, notes how conventional finance generally ignores how real people make decisions and that people make a difference. A second box in the middle notes how investors do not always process information correctly and can infer incorrect probability distributions about future rates of return. A third box on the right notes that even given the correct probability distributions, they often make inconsistent or systematically suboptimal decisions.
Economics 101, it's the idea that investors are efficient, that investors are unemotional, and that investors use information to identify the appropriate financial strategies that provide the very best probabilities of successful outcomes. And while that might be true in textbook, the real world suggests otherwise.
Unfortunately, investors aren't always rational. Investors don't always have access to all the information that they need to draw efficient conclusions or decisions. Investors sometimes are subject to both emotional as well as cognitive biases that lead them astray in this process of investment choice.
You may be wondering, John, I understand the context, but does it really matter? Do these biases and the decisions we make, do they lead to lower returns? Well, a recent study done by DALBAR suggests that there is a difference between the returns that are available to the market participant and the actual returns that they're able to produce.
This differential between the time-weighted rate of return of the market and the dollar-weighted rate of return of the investor, this differential can be substantial.
TEXT ON SCREEN: TITLE – The cost of bad behaviors; SUBTITLE – Introduction to behavioral finance
IMAGE ON SCREEN: A split diagram shows bulleted items on the left and a bar graph on the right. The items note that investment results are more dependent on investor behavior than on investment performance, and that investors are generally their own worst enemy. The bar graph notes how the 20-year average return of the S&P 500 index ended 31 December 2019 significantly outperformed that of the average equity fund investor. The 20-year average annual return of the index is 6.06%, versus 4.25% for the average equity fund investor, with the difference highlighted as a “behavior gap.”
Take a look at the study before you. The average rate of return of the equity market, as represented by the S&P 500, during the selected period of time was just north of 6%.
But how did the average equity market participant do, given their own biases, the decisions they made on when to add capital and when to withdraw it? Unfortunately, they underperformed the market in which they were investing, reducing their return by approximately 180 basis points.
Now you may wonder what's 180 basis points in terms of its impact on my financial outcomes. The difference can be meaningful over time, particularly as we compound wealth over longer time horizons. Take a look at our hypothetical example.
TEXT ON SCREEN: TITLE – The impact of bad behaviors; SUBTITLE – Introduction to behavioral finance
IMAGE ON SCREEN: A line graph highlights the difference in growth of a portfolio with a 6.06% annual return versus one with 4.25% over a 40-year period. The portfolio with a 4.25% annual return grows to $1,966,045, while the one with 6.06% grows to $3,063,750, with the chart noting the difference of a 56% increase. Bulleted items on the left also note the U.S. annual contribution limits of $19,500.
We assume that an investor allocates $19,500 per year into a 401k plan. We then grow these contributions using both the market return of just over 6.0 and the investor result of 4.25, and the difference becomes meaningful. It's over $1 million in terminal value, suggesting this role, this impact of behavioral guidance, can have a material impact on investor outcomes.
Maybe this is a great way for us as financial advisors to communicate our value in the investment management process. We, of course, deliver exceptional advice around investment management and financial planning tactics, but maybe it's the emotional or behavioral coaching that we contribute on behalf of our clients that can produce even more meaningful results on their behalf.
TEXT ON SCREEN: TITLE – 2. Common biases
TEXT ON SCREEN: TITLE – Common biases
IMAGE ON SCREEN: Three biases are listed, each in a box. The biases are loss aversion, recency and anchoring.
Let's identify some of the more common biases. We'll take a look at loss version, we'll examine recency bias, and then finally we'll conclude with the concept of anchoring.
Loss aversion is the idea that losses, or financial declines, are more emotionally impactful than an associated gain. Larry Bird, the Boston Celtics basketball great once said that losing hurts worse than winning feels good.
TEXT ON SCREEN: TITLE – Loss aversion; SUBTITLE – Common biases
IMAGE ON SCREEN: A diagram contains text on the left and a line graph on the right. The graph has four quadrants. The X-axis ranges from losses to the left of the Y-axis in the center, and gains to the right. The Y-axis ranges from less value below the X-axis, to more value above it. The upper right quadrant has an arrow curving upward and flattening, showing that gains bring value. The graph highlights how a $100 gain brings a certain amount of value. The bottom left quadrant has a curve sloping downward, and shows how a $100 loss brings much less value than a $100 gain. The arrow points more steeply downwards, and declines more than the increase shown by the arrow showing the gains.
It's this asymmetrical behavioral or emotional response to a gain in our portfolio as compared to a loss.
Unfortunately, loss aversion leads to some behaviors that are counterproductive. This idea of avoiding loss at all costs sometimes leads us to allocate dollars to safe investment tactics that reduce the probability of a temporary financial decline, but also come with an associated cost, that cost of a lower long-term result.
TEXT ON SCREEN: TITLE – Loss aversion examples; SUBTITLE – Common biases
IMAGE ON SCREEN: A bulleted list highlights various loss aversion examples, such as investing only in safe investments with low returns, holding a stock below purchase price solely to avoid taking a loss, having an unwillingness to sell a home for less than it was purchased for, focusing only on positions that are underwater while ignoring total portfolio holdings, holding the belief that an investment loss doesn’t exist until it’s sold, and selling winning positions instead of losing investments to avoid accepting defeat.
This concept of loss aversion inhibits the client from selling in a security at a price less than what they paid for in an attempt to avoid the acknowledgment of a poor financial decision and booking a capital loss in their portfolios.
Recency bias is also a strong emotional concept that affects investor choice. It's the idea that we look at market returns on a more recent basis, ignoring the longer-term trends and opportunities, but instead focusing on the trend that is afoot at that time, leading us to allocate capital to certain assets that are producing short-term results.
TEXT ON SCREEN: TITLE – Recency bias – trend chasing
IMAGE ON SCREEN: A split diagram shows a line graph on the right and bulleted items on the left. The graph highlights an investor’s behavior and thoughts during a volatile market from 2006 to 2010. A line showing growth of $100,000 invested in early 2006 peaks at around $116,000 in the second quarter of 2007. At this point, the investor is happy to have invested. On the way down, towards the end of 2007, the investment falls to $110,000, and the investor feels that there has to be a recovery soon. By the second quarter of 2008, the investment has fallen to $90,000, and the investor feels they can’t take it anymore and sells. Right after reaching a bottom of $80,000, the investor is happy to have gotten out. But after a recovery, by the time the original investment would have again reached above $100,000 in early 2009, the investor has regret, with a portfolio worth only $93,320 by 2010, instead of $111,694 had they stayed in. On the left, the bullet items note how investors often look at recent returns when making financial decisions. The items also note it’s easier to emotionally validate a choice when we follow a trend, and that this causes investors to chase performance.
Take a look at the hypothetical that we've illustrated. We start our examination in the year 2006 and 2007, and as you probably recall, the market produced very strong results over that period of time. Investors were encouraged. Their investing mood heightened. They added more capital to their investment portfolios, emboldened by these strong recent results.
Eventually, of course, the market returns shift. Market declines come inevitably. Investors became discouraged. Investors lost confidence in their long-term financial plans. Investors used that recent market decline as an excuse to reduce their exposure to risk assets.
Successful investing requires a counterintuitive approach, the idea that it's not always going to be emotionally satisfying to allocate capital to appropriate investments during periods of market volatility. This is a great opportunity for the financial advisor to provide this useful guidance to ensure successful choices and successful outcomes.
TEXT ON SCREEN: TITLE – Anchoring; SUBTITLE – Common Biases
IMAGE ON SCREEN: A split diagram shows a line graph and some bulleted items. On the right, a graph shows the performance of the S&P 500 index from 03 January 2017 to 25 March 2020. The index trends upward over the period, rising to 3,386 by 19 February 2020, up from about 2,300 in early 2017. Yet it crashes in March 2020 to end at 2,476 by March 25. The graph shows a volatile path before to the crash, hitting a low of 2,351 by 24 December 2018, down from about 2,900 a few months earlier. The bullets on the left note that anchoring occurs when investors are influenced by purchase points or arbitrary price levels, and that they cling to these numbers as they decide whether to buy or sell. This prevents them from viewing investments holistically.
The third concept that we should be examining is the idea of anchoring. It's the idea that we hold out a data point from the past as a reference to the choices we make today.
Imagine your client who's thinking about selling their home. They purchased the home ten years ago for a certain price. Five years later that home escalated in value. Our client, when making their decision as to what to sell their home for today, anchors to that higher reference price, using it as a benchmark for their choices or their decisions today, even though there's very little correlation between that past data point and today's fair market value.
Investors exhibit that same behavior when it comes to evaluating prices of securities or their portfolio values, anchoring to higher values at a past reference point.
TEXT ON SCREEN: TITLE – 3. Strategies to mitigate behavioral biases
So, what are some of the strategies and opportunities? What are some of the best practices that we see advisors using today?
TEXT ON SCREEN: TITLE – 4 strategies to mitigate behavioral biases
IMAGE ON SCREEN: A list of four items, highlighted in different colors, includes the following: one, identify behavioral risk, two, enroll in automated investment programs, three, consider asset bucketing, and four, rebalance portfolios regularly.
The first is to identify appropriate behavioral risk. Now I know that risk is a four-letter word, and I understand that measuring and discussing returns can often be more pleasing, but understanding our clients' individual tolerance for risk can go a long way in preparing them for market volatility, and delivering the kind of guidance that's most satisfying.
TEXT ON SCREEN: TITLE – Strategy: Identify behavioral risk; SUBTITLE – Discovery questions
IMAGE ON SCREEN: The image scrolls through a list of eight bullets with one or more questions aimed to identify behavioral risk. Questions include: How has recent volatility affected you? Are you comfortable with your current allocation and holdings? If you received new funds today, how would you invest them? What’s more important to you now: regaining the value recently lost, or protecting the capital you have today? What action would you take if your portfolio increased 10% or decreased 10% next month? What would be more disturbing: holding securities that continue to decline in value, or selling securities that eventually rise? How do you define risk? Which would you prefer: a portfolio with lower volatility and lower returns, or one with higher returns and greater volatility?
How do our clients think about risk? Is risk defined as a temporary loss in market value? Is risk market volatility, i.e., the variability or uncertainty of market returns? Maybe risk is best measured as the probability or likelihood of achieving our individual financial objectives. Unfortunately, risk aversion leads us to do many things that are counterproductive to our long-term financial health.
TEXT ON SCREEN: TITLE – Strategy: Enroll in automated investment programs; SUBTITLE – Dollar cost average at USD$100 per month
IMAGE ON SCREEN: A split diagram shows two tables, representing a rising and declining market scenarios. Each table shows what someone would buy with dollar cost average for each scenario over a four-month period. For a rising market, shown on the left, a $10 stock in January allows for the buying of 10 shares with the $100. The stock rises to $15 in February, $20 in March, and $25 in April, with fewer shares purchased each month, resulting in an average cost per share of $15.58, and an average market price per share of $17.50. For a declining market, a share price in January is $25, allowing for the purchase of four shares. The price falls to $20 in February, $10 in March, and $5 in April, allowing for more shares to be bought over time. Average cost per share is $10.26 and the average market price per share is $15.
Another strategy that we think offers value is the process of automating the investment function, eliminating the variability of emotional response. We've provided you with an example of such an automated process. It's known as dollar-cost averaging, and you realize what dollar-cost averaging implies.
It's the consistent investment of a fixed dollar amount into a defined investment on regular bases. It's the idea that I buy more units at lower prices, I buy fewer units at higher prices, producing an average purchase price that is lower than the average security price during that period of accumulation.
Another methodology is the concept of portfolio immunization, otherwise known as asset bucketing.
TEXT ON SCREEN: TITLE – Strategy: Consider asset bucketing
IMAGE ON SCREEN: A table lists four investment goals down the left-hand side. Characteristics of each goal are arranged on the top row, showing time horizon, dollar amount, priority level and strategy of payment. The payment strategy is shown using pie charts. In this example, each goal has a dollar amount of $1 million. The first goal, buy a second home, has a time horizon of six months, a high priority level, and is to be paid in cash. The second goal, education of four children, has a time horizon that is five years out and four years each, with a high priority and a strategy of payment of a mix of mostly fixed income, with some equities and alternatives. The next goal, lifestyle, has a time horizon of 25 years, with a low priority and would be funded by more equities than anything else, with a good amount of fixed income and small amount of alternatives. The fourth goal, a bequest for the children, is 50 years out, and has a low priority level and would mainly be funded by equities, with some fixed income and alternatives.
It's the idea that I identify specific financial goals in my life: tuition, the purchase of a second home, retirement, charitable giving, and then I identify the timeframe to meet those goals, and the financial resources required to meet those liabilities.
I allocate portfolio assets individually with the appropriate liquidity constraints and volatility assumptions in order to satisfy these goals individually. The mental assurance of knowing that I have short-term capital available to meet short-term financial goals enables me to commit other dollars to more productive, long-term strategies and the associated higher returns that are available through them.
TEXT ON SCREEN: TITLE – Strategy: Rebalance portfolios regularly
IMAGE ON SCREEN: A diagram is split into two columns, which explain the potential benefits and additional considerations for rebalancing portfolios regularly. Potential benefits include addressing portfolio drift, reducing volatility, instilling a disciplined approach, and buying low and selling high. Additional considerations include the impact of taxes and fees, sources of funds, and methodology used.
The final strategy is the concept of portfolio rebalancing. Rebalancing forces the investor to do what's emotionally uncomfortable but financially productive. Think about what rebalancing implies. I'm removing assets from an asset class that's done well recently and I'm redeploying them into assets that have done less well and are trading at a lower valuation.
Rebalancing not only provides a risk and return benefit financially, but rebalancing instills discipline into the financial landscape that can be beneficial to the retail investor.
TEXT ON SCREEN: TITLE – Portfolio rebalancing after market decline
IMAGE ON SCREEN: A diagram displays two pie charts and accompanying tables to show the required portfolio rebalancing after a market decline. A pie chart on the top left shows the initial allocation of a $1 million portfolio in January 2008 to hold 30% in fixed income, 25% in large growth, 25% in large value, 10% in small capitalization stocks, and 10% in international stocks. A table in the top center shows the roughly 35% to 41% declines in the equity categories and a 6% gain in fixed income in 2008. A pie chart on the top right shows the resulting allocation in January 2009 for a portfolio now worth $753,525: 42% in fixed income, 20% in large growth, 21% in large value, 9% in small cap, and 8% in international. A table at the bottom of the diagram shows how $91,883 needs to be moved out of fixed income and spread among the other four asset classes to bring the allocation percentages back to their January 2008 levels.
We've provided you with an example of how rebalancing works, starting with the $1 million portfolio on the left, allocated 70/30 between stocks and bonds.
We examine the market results of 2008, a period of significant market drawdown. A year later, after the significant market decline, we can see that the overall portfolio has dropped, but maybe more importantly, the client weightings have shifted.
The client's allocation in equities has dropped from 70% to 58%. Fixed income now represents a larger component of the overall portfolio mix. So I ask a rhetorical question. After enduring that significant period of market decline, how many investors were willing to rebalance their portfolios, to add more money to the asset class that just produced those significant declines in value?
In fact, anecdotally, the evidence that I've heard is that most investors not only were unwilling to add money to equities, but in fact were contemplating reducing their equity exposure, given the significant financial decline and emotional instability that they suffered during that period. Rebalancing forces us to instill discipline into the decision-making process that can help to mitigate some of these strong emotional biases.
Thank you for spending some time with us today to discuss this very important concept of behavioral guidance. We encourage you to visit us at pimco.com or to contact your PIMCO account manager to learn more about the resources we've made available to support your efforts in this area.
TEXT ON SCREEN: To learn more visit pimco.com/advisoreducation or speak with your account manager
TEXT ON SCREEN: PIMCO
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