You would like to say “NO!” but you know better.
Daniel Kahneman is a psychologist who won the 2002 Nobel Prize in economics. An interesting combination. How could that happen? Perhaps the stock market is psychotic. It is more likely that the people who invest there are not completely rational. We can and should learn from that. Kahneman has some interesting things to say in his 2011 book, “Thinking, Fast and Slow”
Investment statistical material and techniques assume a fully rational, fully informed trader and are therefore almost certainly imperfect. Something else must matter, too. I suggest that learning to manage yourself may be as important or even more important than learning to manage your money.
If you expect 7% and get 8% you are happy. You won. If you expect 9% and get 8% somebody has some ‘splainin’ to do. At an emotional level, people do not compare results to what is rational and objective, they initially compare results to their expectations. Only later and only sometimes will they put the the rate of return in context of what they were trying to accomplish.
Rule 1: When the outcome is not as expected, it is not the event that causes the problem it is the comparison to expectation.
If clients use only a comparison to expectation to decide if the results are good or bad, they are not being rational. The yield is what it should have been, it is the expectation that was wrong. Kahneman has pointed out that, emotionally, losses are twice as disappointing as gains are pleasing. Clients would need to beat expectation twice as often as they lose to expectation just to break even emotionally. That is not going to happen.
Advisers can help mitigate the problem. Keep reporting focused on the goal, not the yield.
Setting expectations and reporting results so that the emotional response to shortfalls is in context, is an important part of the adviser function. It is one of only a few things that can make or break the client relationship.
Expectation is everywhere. Friends, family, bosses and associates have expectations and they are unhappy when you don’t meet them.
If we go golfing and each arrives back home at 8:00 different things happen. If I told my wife I would be home at 9:00 and you told your wife that you would be home at 6:00, we will see asymmetric results from a single event. You would think that a single, objectively verifiable event, being home at 8:00, would always generate the same outcome. You would be wrong!
Rule 2: Comparison to expectation matters, so be cautious about what you cause people to expect.
If you build a financial plan with an interest assumption of 6%, that will become the carved in stone expectation. You better hope the first year or two are higher. Average returns will only save you later.
Especially, be cautious about implicit expectations. While we may say past performance does not imply similar future performance, that is not how people understand the world. All of us use the past to help estimate the future. Recent events easily translate into expectations for the future. When current results are good, it is especially important for you to emphasize that the past does not predict the future. Congratulating yourself will merely reset the expectation higher. A guaranteed to fail tactic.
Rule 3: Comparison to expectation overwhelms facts.
Suppose I meet you at a New Year’s Eve party. You decide to let me invest $25,000 for a year, just to see what happens. You have no firm expectations, just hopes.
A year later I am happy to tell you that your $25,000 investment is worth $1,000,000. Clearly unexpected but very nice. You let me continue for another year and at the end of that second year, your investment is worth $75,000.
I don’t know what will happen for year 3, but I know you are unlikely to introduce me to your friends as the person who tripled your money in two years.
Write down Rule 4: At an emotional level, there is such a thing as a paper profit, but all losses are real.
You cannot be a successful investor or a successful adviser if you cannot manage expectations and the emotions that arise from the events that follow.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. firstname.lastname@example.org
Follow on Twitter @DonShaughnessy