2 Investment Theories that are Critical in Today’s Market


2 Investment Theories that are Critical in Today’s Market

When you’re done reading this, you should Google “investment theory.” You will find more than 577 million articles, videos, news releases, opinions, and thousands of different types of investment theories. It’s mind-boggling to think of the different ways you can manage assets in this industry. 

 

The problem is we forget that the most important part of managing assets is making sure our client understands and feels comfortable with the direction of their portfolio. Maybe even more important is how our clients make decisions. 

 

Out of the millions of Google results, there are two theories that I find relevant in today’s investment management market: Prospect Theory and Recency Bias. Understanding how your clients react to these two behavioral theories is important in how you manage their expectations and set the course for their retirement strategies.  

 

  • Recency Bias assumes you are going to get the same result as you have previously when there is a chain of consistent events. For example, if you watch a football game and the kicker is setting up for a game-winning field goal, you assume he will make it because of his high percentage of successful kicks and the fact that he has already kicked several field goals earlier in the game. In reality, he has no better chance of hitting that field goal than any other kick. But, our recency bias tells us that he will make it. In investing, the recent gains in just about every asset class make us think that the equity and bond markets will continue to increase. In reality, there is no fundamental reason to believe that the chances of continued equity market increases are greater than they have ever been. We just perceive that the markets will go up. And, our clients feel that way when they make decisions. 

 

  • Prospect Theory addresses the willingness to avoid loss. In most cases, clients feel a loss 2.25 times more than the same amount of gain. They tend to choose products on how they are positioned. For example, let’s assume that the total return for a client in two different scenarios is $25 for the same, two-year fixed period. One results in a steady gain of $25 over the two years, or $12.50 for each year. Another scenario allows the client to achieve a $50 gain in year one but a $25 loss in year two, resulting in the same net $25. Most clients tend to choose the first scenario because they have a tendency to look for gains and avoid losses, even if the result is the same. 

 

As we start to look into 2018, think about how your clients might be affected by different market scenarios. How likely are they to get scared or concerned if they don’t see the steady growth of their retirement dollars? Is your practice in a better position by making sure your clients feel better about steady growth versus random fluctuations in the market? Make sure you understand what your clients are feeling in order to build the portfolio that best matches their goals. 

 

Winning Strategy

Understanding how clients react to recent events and potential gains and losses is just as important as managing money to benchmarks. Take time to ask the right questions and look at alternatives to address behavior and money management theories. 

 

About the Author

Mike McGlothlin is a tireless advocate for the retirement planning industry. As executive vice president of retirement at Ash Brokerage, he heads a team providing income planning solutions focused on longevity and efficiency. He’s also a thought leader who provides guidance and assistance for advisors and broker-dealers navigating marketplace and regulatory changes. You can find a collection of his blog posts in his book, “Above the Clouds … Winning Strategies from 30,000 Feet.”