Content provided by Paula Wieck, CLS Manager of Investment Research/Portfolio Manager
I had the opportunity to speak to several advisors last week about their businesses. A couple of these conversations resonated with me, particularly because this subject has come up frequently. One advisor’s client was contemplating whether or not to relieve him of his services because the client had a one-security portfolio that was doing better than his advisor’s diversified allocation over the last few years. As you may have guessed, the client had a domestic large-cap fund, which happens to be one of the best performing asset classes during this time frame. The client asked him, “Why am I paying you a fee when I can have better performance myself?”
I’m not going to preach the benefits of diversification as most readers likely get it. Instead, I’d like to talk about how to coach an investor like this.
First of all, the client is suffering from an emotional bias. When I talk about emotional investing, I’m not just referring to panicking at market bottoms and buying at market tops (herding). This client is emotional because he is overconfident.
Overconfidence bias is an emotional bias in which people demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities, according to the CFA Institute’s definition. Because this client picked a security that has outperformed most other asset classes over the last few years, he likely perceives his success as superior knowledge or skill, leading him to estimate the probability that his investment will outperform as greater than it really is.
The implications of overconfidence are the underestimation of risks and overestimation of expected returns. That can lead to poorly diversified portfolios and lower returns over longer time frames. Ouch!
In the currently advancing bull market, I’ve seen so many investors exhibit overconfidence as it feels easy to make money in this type of environment. But as the old adage on Wall Street goes, “Don’t confuse brains with a bull market.” In other words, don’t overestimate your investment skill when most of your success is attributable to a rising market. Chances are the client’s “skill” will do little to help him when the U.S. market corrects.
How can we, as financial professionals, coach these types of clients?
First, we should challenge them to review why they chose their investment(s) and whether that rationale still holds. Second, we should encourage them to review the long-term performance of their portfolio compared to a broadly diversified portfolio. Because this is an emotional bias, bringing the conversation to a more cognitive and analytical level should invigorate them to review their investment practices and realize that perhaps they have had more luck from a mature bull market than they’d like to admit. Unfortunately, that luck doesn’t usually last.