Helping clients keep their emotions in check can prevent them from losing sleep over their investments or abandoning the market when their returns appear to be falling short of their expectations.
Experience shows that clients are likely to become more emotional about their investments the more frequently they check their returns. Thus, it is prudent for them to check their investment returns less frequently, recognizing that they are investing for the long haul.
That is the concept behind the “Wheel of Investor Emotion,” a tool created by Bridgehouse Asset Managers in Toronto — to help clients keep their emotions in check.
The principles on which the “wheel” operates are based on two academic publications: Prospect Theory, also referred to as “loss-aversion theory,” by Daniel Kahneman and Amos Tversky (1979); and Fooled by Randomness by Nassim Nicholas Taleb (2001).
Prospect Theory measures units of emotions gained or lost and states that people value gains and losses differently. This theory says investors will become more emotional about losses than about gains. As a result, they may base their decisions on an aversion to short-term losses rather than on potential long-term gains.
Alternatively, Fooled by Randomness shows that the more often investors check their portfolios, the more likely they are to see a loss.
Bridgehouse’s “Wheel of Emotion” provides investors with an experience they can handle, says Elizabeth Hoyle, chief marketing officer with Bridgehouse. It helps clients think long-term about their investments instead of looking at their returns frequently.
If investors look at the performance of their investments less frequently — for example, annually, which corresponds to the typical advisor review period — they are likely to be “most happy.” If they review their investments daily, they will “experience a lot more stress.”
Hoyle likens the investor experience to watching a pot of water boil. “It will not boil faster if you look at it,” she says.
This argument is based on research that shows markets perform better over the long term despite volatility over shorter periods.
The wheel, which is available in both hard copy and digital form, enables clients to measure emotional gain and loss resulting from checking their portfolios using four frequencies: daily, monthly, quarterly and annually. Calculations are based on the following assumptions: an investment period of 20 years; annual return of 15%; and annual volatility of 10%.
The assumptions about emotions are based on the findings of Prospect Theory, which state that for every good result a client sees, one unit of emotion is gained. But when a bad result is seen, two units are lost, because a loss has twice the emotional impact.
So, if an investor checks his or her portfolio daily, the chance of seeing a gain is 54%, which represents a bad-to-good ratio of 2:1 in emotional units. Over a 20-year period, that would result in a gain of 3,942 units of emotion and a loss of 6,716 units of emotion. And an unhappy client.
Alternatively, if the investor checks his or her portfolio annually, the chance of seeing a gain is 93%, which is roughly a 10:1 good-to-bad ratio, resulting in a gain of 19 units of emotion and a loss of 2 units. And a happier client.
To view the tool online, visit:
http://bridgehousecanada.com/wheel-of-investor-emotion/
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