Avoiding Today's Lurking Behavioral Land Mines

Christine Benz: Hi, I'm Christine Benz for Morningstar.com.

A big part of a financial advisor's job is to help clients stay the course and avoid big landmines. Joining me to discuss some big landmines that lurk today is Mark Balasa from the firm Balasa Dinverno & Foltz.

Mark, thank you so much for being here.

Mark Balasa: My pleasure.

Benz: Mark, let's talk about how big a role some of these behavioral pitfalls play in terms of what you do as a financial planner. How much do you help counter clients' own worst tendencies?

Balasa: I think in many ways, it's the biggest part of our job. When I first came into this business, I thought that one of the most important things about helping a client with their portfolio was understanding a particular investment theory, asset class valuations, etc., and that's important. But what's really important is to help someone counter their own intuitions and emotions.

Think about some of the biggest investment firms in this industry, take PIMCO for example. PIMCO has an investment committee that puts together their best thoughts and their best ideas. But they have a shadow committee, that's there to provide a counter argument to what they are thinking, and this I think is a great example of even the professionals in the business putting in place mechanisms and safeguards against getting too emotional, one way or the other, and that applies to individual investors as well.

Benz: When you think about your clients and some of the things that have tripped them up over the years, can we talk about how some of these behavioral mistakes have played out in your practice? And then, I'd like to hear about how you help coach clients to counter their own instincts?

Balasa: So many times, people come to our firm with financial scars, emotional scars. Many times of course, it's on the loss side. It's either they were too concentrated, they stayed in a particular stock too long, all kinds of different stories. But what ends up happening for the individuals, and for professionals frankly, is they start to make decisions not based upon good economic sense but based upon either their view of what a stock should be worth or an anchoring, for example.

So I'll give you an example of people who come in and they say, my portfolio was at x number of dollars, and this is what I held; we're not going to sell any of these until we get back to even. So then we can make some choices, because I'm not going to recognize a loss.

So I understand the emotional pain with realizing a loss, but that doesn't make great investment sense. So, that's one example that comes to mind.

Benz: The 2008 market meltdown, really I'm sure, created a lot of scars for investors. Are you still seeing those when you talk to clients? Are people still exhibiting behavior that show that they are very much plugged into what happened to them in that very bad market environment?

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Balasa: They really are. One way I'd describe it is, it's just beneath the surface. The equity markets have done really well since '08. But there's been, as people I'm sure remember, a few different swings, mostly because of problems in Europe, where the market dropped 15%, almost 20%. And that brought out immediately people's concerns about, gosh, we're not going to go back to 2008-2009, are we? What do we know that's different? How can you help protect against that?

So to your point, the markets have been great and people in some ways are getting more comfortable with it, if you will. Some sense that they almost feel like they have to get on because it's moving. But right underneath the surface is that concern.

Benz: When you think about bonds today and how your clients are reacting to the bond environment. For a while there, we had been seeing a lot of flows going into bonds, and I think that a lot of people have really been screeching to a halt on that front recently as we've seen bonds go down. How are your clients responding in the wake of all the volatility that we've had in the bond market recently?

Balasa: In some way, it's the same. I mean, they are concerned, although we've been talking internally to them for the better part of a year about eventually bond rates are going to go up, interest rates are going to go up, and bonds are going to be challenged. Last year, bonds did fabulous, though. So this year, just as you described, all of a sudden last couple of months, bonds have done bad.

And so, people tend to look at that, and because they're so concerned about losses, they are … proposing, or if you look at flows into mutual funds as you just described, people are leaving bond funds. And some of our clients are asking, should we sell the bond fund? The immediate question is, but where are you going to go? Cash has no return. Real estate is in some ways recovering, but the other big asset class is stock. There's a very big difference in terms of the risk of stocks swinging as opposed to bonds. And so, the knee-jerk reaction I think for many people is to sell something has a loss--that's in some ways the easiest question to answer. The hard one is where would you go with it? And so that's where those conservations get more involved.

Benz: In that kind of situation, do you try to find a sort of happy middle ground, where you say, I understand that you are concerned about bonds, maybe we can adjust the bond positioning a little bit, so that you are comfortable with it, and these risks that you're worried about may not be as big anymore?

Balasa: It's exactly right. You're trying to say, on the bond side, there are a couple of things: one is we can do some things to help insulate against further turmoil, shorten the duration, look at the credit quality, go outside the United States for other opportunities, and using in some cases these unconstrained-type products that have more flexibility.

So those are some things we can do. But at the end of the day, part of it is thinking about expectations. What are your expectations for bonds? Do we need to ratchet those down a little bit to be realistic. Because if you make, again, short-term decisions based upon a little bit of volatility there, and you go into an asset class that has five times the volatility, is that the right thing to do for the portfolio as a whole? In most cases the answer is no.

Benz: You mentioned that a lot of investors still have a strong appetite for some other asset class. So there are stocks, bonds and cash, but there is the appeal of, is there something else. Is an alternative investment something that we need to add to the toolkit? What do you say to investors who come to you and say, should we look at some of these alternative asset classes, and how do you coach them from sort of chasing the trendy investment of the day?

Balasa: I think there's always benefit in looking, because there are always new ideas, different ways of approaching things. But in that process, be very cautious, be very deliberate about what you are buying and putting into your portfolio. Many times it's very expensive or it's tax inefficient, it's illiquid or it's unproven or some combination.

That being said, there's some good new ideas out there. But this last couple of months has really highlighted how difficult it is to avoid turmoil. So think about gold year-to-date, you think about commodities, you think about risk parity--all these different things have potential benefits to a portfolio, but none of them have helped this year. Whereas a bond, … the Barclays [Aggregate Bond Index] is negative, but it's only down a couple of a percent. So in the grand scheme of things that's not bad for a bad couple of months relative to what we saw in '08-'09 for stocks. So again, I think it's great to look at new ideas and things that are additive to the portfolio, but be very deliberate.

Benz: Equities, we haven't talked about, but I'd like to hear about how the fact that we've seen a really strong run here for equities, does that tend to stoke investors' overconfidence, for example? Are you seeing anything, any behavioral tendencies, that are stoked by the very strong market returns?

Balasa: There's no doubt it stokes emotional and behavioral issues--there's no doubt. Invariably when '08 and '09 happened--not to go back to that too many times today-- people felt … it's never going to stop dropping. And then you look at the last couple of years, especially the last 12 months of equity returns, they're going up, well, [investors think] they are always going to go up.

Benz: That recency bias.

Balasa: Indeed, right. So everything reverts to the mean over time. So yes, I think people that wanted to dial back on risk, and we changed their allocation to reflect that are now saying, well, gosh let's go back. I'm not sure that's the right thing to do. Depending on whose valuations you look at, the market is somewhere between cheap and very expensive. So for us, I think the big long-term strategic approach is still the best approach as opposed to subjecting yourself to these short-term trends if you will.

Benz: You mentioned, Mark, that some of your new clients might come to you with a portfolio that's positioned in quite a risk-averse way. So, it might have a lot more cash than it would be ideal. How would you approach a situation like that in light of the fact that equity market valuations aren't particularly cheap right now?

Balasa: It's a delicate balance. This is a great example of behavioral finance, where ideally you might pick this solution, but … to keep the client in the game, to keep them moving forward, to keep them in their seat and not change all the time, you have to balance what's ideal versus what they can accept.

And so in some cases it's putting a little bit at a time. In some cases it may be having more of an asset class than you otherwise would, etc. But you are trying to balance what it's going to take for that person--in many cases, that couple, which makes it even more challenging, because one spouse will be here and the other spouse here. So how do you find a middle ground that will allow them to keep the portfolio strategically long-term focused as opposed to reacting to all the short-term influences?

Benz: When you think about how individual investors who don't have financial advisors working with them to keep them in their seat, can you offer any guidance to them about how to kind of counsel themselves, or would you say that everyone needs at a minimum sort of an investment buddy to help them talk through various decisions that they might be considering?

Balasa: I encourage everyone to have at least an investment buddy. I come back to my example with PIMCO and their investment community and the shadow committee. These people have all of the experience and the bright folks at their beck and call to solve an issue. But even they want to be challenged, because you can get subject to group-think, and you can get subject to your own thoughts--all of these behavioral things that you are talking about here.

So if you think about investing in general, I once read a code about being disciplined and detached. I think that makes a lot of sense. And a certain amount of detachment here is good; don't look at it every day. Don't dwell on it. Maybe look at it once a month if you are diversified--I'm not talking about individual stocks so much here.

But to be disciplined and be detached and have someone that can give you that counter--because when you read too many articles, you watch too many shows, you listen to too many buddies at the barber shop, you get emotionally wound up one way or the other. It's really good--a spouse or a friend, golf buddy to say, "Slow down. Remember that story last time? Yeah, that didn't work out so good." So I think it's helpful.

Benz: Mark, great advice as always. Thank you so much for being here.

Balasa: My pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.