Last week’s column outlined how monitoring ongoing progress can help achieve short-term goals, inspired by a recent New York Times article on finishing times in marathons. That article, titled What Good Marathons and Bad Investments Have in Common, addresses what behavioral economists call “the disposition effect,” academic-speak for the unwillingness of investors to sell an investment when it entails crystallizing losses, even when it would otherwise make sense to do so.
We saw this in the housing downturn, as Americans stubbornly hung on to their homes waiting for prices to get back to what they paid. And every advisor has run into this reluctance on selling stocks that are down sharply. The good news – research on an approach called “pre-commitments” sets out a path that can help you persuade clients to make a tough decision when the original rationale for making a purchase has changed and it’s time to take a loss and move on.
Warren Buffett’s take on loss aversion
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The concept that investors are averse to losses is far from new, but it was first quantified in research by psychologists Daniel Kahenman of Princeton and Amos Tversky of Stanford. Their 1979 paper “Prospect Theory: An Analysis of Decision Under Risk” is a seminal work that explores what appears to be irrational decision-making:
- Facing a 95% chance of winning $10,000, the average consumer accepts an unfavorable offer of $9,000.
- But the same consumer, facing a 95% chance of losing $10,000, rejects a favorable offer of paying $9,000.
Their conclusion: “Losses and disadvantages have greater impact on preferences than gains and advantages.” Kahneman received the 2012 Nobel Prize in economics for this work (Tversky had passed away and thus was ineligible). The reluctance to sell losing investments was further quantified in 1998 research by Terence Odean of University of California Davis who analyzed trading records of 10,000 accounts at a large discount brokerage house. His conclusion: Investors reduce returns by selling winning investments too soon and holding losing investments too long.
Contrast that with Warren Buffett, the ultimate rational investor. Buffett underwrote last spring’s Billion Dollar March Madness Challenge. Sponsored by Quicken Loans, consumers could go online and pick the winners for all 63 games in the NCAA – anyone who picked all games correctly would win $1 billion, receiving $25 million annually for 40 years. Buffett received a rumored $10 million to take on the risk of someone winning. Asked what he would do if someone picked all the games correctly going into the last game, Buffett answered that he would invite him or her to sit with him at the final game – and then offer $100 million to call off the wager.
Of course, it’s not just in investing and making wagers that people are risk averse and display irrational behavior. As one example, the New York Times article pointed to puzzling behavior by workers who when times get tough will agree to a wage freeze, even when inflation is 4%, but won’t agree to a 1% wage rollback when inflation is 1% or 2%. That has led to research by economists with Federal Reserve Bank of San Francisco showing that wage increases today overwhelming cluster at zero.
Using pre-commitments to overcome emotions
When you talk to clients about taking a loss on an investment, you have to deal not only with the rational case for selling but with their emotional response. And we all recognize that making decisions when our emotions are aroused rarely leads to good outcomes.
The solution is to gain a commitment from clients before the actual decision has to be made, when reason is what dominates decision-making. This article describes the Save More Tomorrow Plan, which has been demonstrated to significantly increase savings rates. Developed by the University of Chicago’s Richard Thaler, the plan doesn’t ask workers to reduce income today, with the obvious emotional response. Rather, it asks people to sign a form that goes to their company’s payroll office, directing a large proportion of future salary increases to be automatically diverted to their savings.
Companies who offer this automatic escalation of savings have seen a significant increase in overall savings rates; as the Wall Street Journal’s Jason Zweig points out, this is especially the case where employees are automatically signed up for the savings escalation program and have to opt out if they don’t want to increase savings.
The same principle applies to gaining a commitment from clients in advance of an actual decision needing to be made – research shows that once a commitment has been made, people are likely to carry through on that commitment in order to maintain consistency. In fact, commitment and consistency are one of the six key drivers of persuasion outlined by Arizona State’s Robert Cialdiini in his groundbreaking book, Influence: The Psychology of Persuasion.
Some ways that you can incorporate pre-commitments into client conversations:
When buying investments, identify a price (both on the upside and the downside) that will automatically trigger a review of whether the original case for buying that investment still applies. Ask clients whether if the fundamental rationale for that investment has changed, they will be willing to sell it. Even though this should be a non-issue, to increase the chances of clients following though it’s important to get them to actually say “yes.”
- One advisor I know has had success in reducing anxious calls and keeping clients invested in volatile markets by having a conversation with new clients about how large a decline in the value of their investments would trigger a phone call or meeting to review their situation. As part of this discussion, he shows the frequency of market declines of 10%, 15%, 20% and 25% and typically suggests that a 20% decline would be the right number to prompt a call.
Virtually every client agrees – and then the advisor takes this one step further. He tells clients that he’d like to document their agreement for their file and he signs this commitment that he will be in touch if the market declines by 20% and then has them sign it as well. Getting it in writing significantly increases the chances of people sticking to their commitment.
- Pre-commitments don’t apply just to clients. One advisor who runs dinner seminars for prospects has reduced no-show rates by a simple expedient: When people call to book, his assistant says – “Will you call me if something comes up and you can’t make it?” and then waits for the prospective client to agree. By doing that and that alone, no-shows have dropped significantly.
Asking clients to make decisions when their emotions are aroused seldom leads to good outcomes. By incorporating pre-commitments into your conversations, you reduce stress on clients and increase the chances of better decisions..
Dan Richards conducts programs to help advisors gain and retain clients and is an award winning faculty member in the MBA program at the University of Toronto. To see more of his written commentaries, go to www.danrichards.com or here for his videos.
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