Welcome to Financial Advisor IQ
Follow

Learn to Play Psychologist Around Loss Aversion

September 8, 2017

This time we hear from Mitchell Kraus, a financial advisor with Capital Intelligence Associates located in Santa Monica, Calif. He describes how he drew on his psychology education to understand clients’ seemingly illogical reactions.

As a financial advisor I spent years making recommendations that were extremely well thought-out but were often not implemented by clients. My advice could be well-researched and logically sound but clients would either not take action based on the advice or start the process and not see it through.

My first recollection of seeing truly illogical financial behavior was during the dot-com boom and bust in the early 1990s. A good friend from college was very concerned about her parents’ financial situation and asked if I would meet with her father. He had put all his money in CDs and treasury bills and managed to save well over $1 million. In 1999 he decided to take this easy money and put it all in dot-com stocks. By 2002 his portfolio was cut by a third. I told him to get out before he suffered further losses. He said, “I can’t. I need to make this money back so I can retire.”

He was holding on to assets that didn’t fit his financial needs. I realized at that point that I could spend all day walking him through the logical underpinnings of my advice but to actually get through to him — to get him to take action — I needed to do more than just give him a logical explanation.

This experience was my inspiration to call on my educational background as a psychology major. I decided I needed to ask questions beyond just “When do you want to retire?” and “Where do you want to your kids to school?” I needed to understand the 'Why?' behind clients’ actions.

With this particular client I knew what was in play: “loss aversion.” Psychological research shows that losses loom much larger in the emotional landscape than gains. The emotional pleasure of a gain is equivalent to the emotional pain generated by losing just 50% of that gain. This explains why people facing losses make decisions that seem illogical.

Even though I understood the psychological concept behind my friend’s father’s decision, I still wasn’t sure how to counteract this kind of deeply-embedded human way of thinking. After mulling it over I decided the best approach would be to start early in the client relationship rather than waiting until a loss event.

At my very first meeting with a prospect I needed to ask the right questions to determine if they were someone who was likely to sell in a panic when faced with a down market. If this was true I needed to work with them when the market was good to help them understand there would be times of losses. Educating them early on would help ensure that when the market did go down they would be able to respond with, “Oh yeah, you told me this was going to happen.” They wouldn’t like suffering losses in the moment but would understand this was part of the process of reaching their goals.

Today I work to help clients feel loss when it’s not really there so they can better weather the times when losses do happen and emotions start rising. It’s unfortunate that my friend’s father ended up with a portfolio worth one-third of its original value. But that experience was invaluable for me and for my future clients.