When market volatility rises, our first impulse can be to cut and run. But that’s a biologically conditioned emotional response rather than a logical one. In this episode of Portfolio Intelligence, John Bryson is joined by Keith Van Etten, portfolio consultant and behavioral finance specialist at John Hancock Investment Management, to investigate our intuitive responses to stimuli versus our logical curbing of emotionally driven reactions. Applying these insights to investing, they discuss mental anchoring, unconscious simplification strategies, and other situations where listening to our gut can get our portfolios into trouble. This podcast is distributed by John Hancock Investment Management Distributors LLC, member FINRA, SIPC.
John Bryson:
Hello, and welcome to the Portfolio Intelligence podcast. I'm John Bryson, head of investment consulting at John Hancock Investment Management. The goal of this podcast is to help investment professionals deliver better outcomes for their clients and their practice. Topics we'll address include advisor, business-building ideas, capital market updates, the latest trends in portfolio construction, and investment insight from our veteran portfolio managers across our network. We learned early in our investment career some key tenets such as buy low and sell high, have a long-term plan and stick with it, markets and investors are generally rational and shouldn't let emotions get involved in their decision-making. All of those sound good, but they're not necessarily easy words to live by, especially when markets get extremely volatile and your net worth declines by a large amount.
There's been a lot of research and study of financial markets and investment strategies. There's also been a lot of study of human behavior. Behavioral finance looks to combine both of those, and we want to spend some time today talking about what behavioral finance is, how you can understand it better, and put it to work to your advantage. Today, I'm joined by Keith Van Etten, portfolio consultant here at John Hancock Investment Management. Keith and I have both studied behavioral finance and we'll be discussing a few things like the human brain and how it functions, heuristics and biases, how those heuristics and biases lead to decisions and potentially, investor mistakes, and ideas on how to avoid those mistakes.
Okay, let's start by spending a little time understanding the human brain and how we make decisions because it'll give important context of some of the investment behaviors that we want to talk about. As much as we like to think as ourselves as unique individuals, the way we process information and make decisions is actually more common than many understand. Many researchers talk about two systems that we have for making decisions, an intuitive system and a logical one. Keith, can you expand on that?
Keith Van Etten:
Sure. They're commonly referred to as system one and system two. Daniel Kahneman brought them to the forefront in his book, “Thinking, Fast and Slow,” but actually many credit a Ph.D. from the University of Massachusetts, a gentleman by the name of Dr. Seymour Epstein, as having originated the concept. In a nutshell, the theory goes that we have two modes of thinking, an intuitive one which is fast, reflexive and built for immediate action. Its primary goal is to protect us by keeping our reaction time to a minimum. It's frankly less concerned with being right as it is with being safe. And as you can appreciate, this was critically important for early humans as that rustle in the grass could be either the wind or it could be a tiger stalking us.
John Bryson:
Yeah, that's an important point to make at the outset that our brains have evolved over millions of years and we've only recently been using them for investing, let's say, for the last a hundred years. Our brain really wasn't designed originally to navigate a complex set of markets. That's the second system. Tell us about system two.
Keith Van Etten:
Well, system two evolved much later because it really wasn't basic to our survival back then. Detecting danger and recognizing opportunities were the two primary functions of the brain from an evolutionary perspective, and they're associated with system one. So our logic function, system two, actually resides in our neocortex, which scientists believed evolved much later. And what's really interesting is that with system two, it's also responsible for controlling the emotional response of system one. So from that perspective, it's like the big brother watching over their impulsive sibling.
John Bryson:
So with that example, when people are under great stress, like fear or panic, it's really all about system one at work. Let's talk about the psychological response that occurs because of this chain reaction, isn't this where the amygdala comes in? Tell us about that.
Keith Van Etten:
Yeah, it begins with the amygdala, which it's pretty small, it's actually all almond shaped, and it's located close to the brainstem and it's located there for a reason. It's really the early-warning system for the entire body. It's always turned on; it's always monitoring the environment for threats. And when it senses one, it goes code red and starts a chemical reaction within the brain by releasing the chemical adrenaline, which actually puts everything, the entire body, on high alert.
John Bryson:
Yeah. And those similar studies, they've really learned that blood is diverted from the logical parts of the brain and sends it to where it's needed most like the muscles for action, and that's the fight-or-flight response, right?
Keith Van Etten:
It is. That's where you hear stories is about people with road rage that are normally mild mannered, but you'll get that response in a variety of situations that aren't so obviously threatening as that. For example, you're walking down a dark alley and you hear a noise, the body will go on high alert even when there's no obvious threat, just the chance of one. That's the chill you feel, frankly up, your spine. And that's system one in action. It assumes false positives, which means it reacts to threats whether they're real or not. From that perspective, its motto is really better safe than sorry.
John Bryson:
Yeah, and I've also read that it's not just in that situation, simply the memory of that type of stressful situation can trigger the same response. So that's a good transition for us, let's talk about how investors react to market volatility. Research has shown that investors process investment losses in the same part of the brain as mortal danger, like we've been talking about, which helps us explain why they sell at market bottoms despite the logic stating that it probably isn't in their best interest for the long term.
Keith Van Etten:
Well, that's a great point because system one is built to react to false positive. It naturally assumes cause-and-effect relationships even where none exists. So again, system one is not built to question whether the threat is real or fake. It just reacts. It's really up to system two to override the emotion, but that's difficult to do in periods of extreme volatility in the market.
John Bryson:
Yeah, no doubt. We also understand that the brain is a pattern-seeking device and it doesn't understand mean reversion. In other words, it's prone to think that when a market is falling, it's going to continue to fall.
Keith Van Etten:
Yeah, that's right. That's why it's critical to get investors to shift from system one thinking to system two thinking in these situations, but you need to do it methodically. I mean, bombarding them with logic out of the gate is really a little use when someone is panicking, so you really want to first calm them down and acknowledge their emotion. And in these situations, a technique we use called PAUSE can be useful. The P literally refers to getting the client to pause and slow down for a moment. For example, you could say, let's just take a moment and talk about this. The A in pause stands for acknowledge, and you want to acknowledge their emotion but not necessarily their point of view. For example, it can be as simple as, I can see this is concerning you. You want to show empathy, which is critical to building trust, but that's different than agreeing with their emotion. Your goal after all is to get them to calm down and listen to logic. And once you do that, you have a better chance to coach effectively and ultimately, get them to see the illogic of what they're thinking of doing.
John Bryson:
Yeah, and I'm sure that takes a lot of patience. So throwing more data at essentially what's an emotional response when the brain is almost starved for the fuel that it needs to fully function, that's simply not going to work. Neither is somebody telling somebody simply to stop worrying and everything's going to be all right?
Keith Van Etten:
Exactly. And that's where the U comes in in PAUSE—it stands for understand. For example, you could say, if I'm hearing you correctly, your concern that X may lead to Y and cause Z, is that correct? So you're restating their concern so they know you heard them, but in a manner that is more measured, then you get them to either confirm or clarify their response. What you ultimately want them to do is to reflect on their own logic, which begins to pivot from system one thinking to system two thinking. And that's where the S comes in, which stands for search. You're searching for all the other alternatives to their narrow scenario. You explore as many of them as possible or as practical because you know at the end of the day, a fundamental decision area in these situations is really something confusing, something that's plausible with something that's probable.
John Bryson:
So in other words, yes, it's possible the market could keep going down because of all of these reasons, but that's not what's most likely over the long term.
Keith Van Etten:
Yeah, that's right. So there are any number of other outcomes that we need to consider that are just as possible or perhaps even more probable based on history, and this is the critical point to system two. You're making the critical pivot, rather. You're making them confront multiple alternatives to their scenario, which brings up the final step in PAUSE, which is E for evaluate. What you're trying to do is you're trying to bring them back to a long-term perspective.
John Bryson:
Okay. Let's continue on this theme of plausible versus probable because it seems like it's a common decision error. Does that refer to a specific behavioral bias or heuristic identified through research?
Keith Van Etten:
Yes, it's called representativeness and it's actually heuristic, which is ... Heuristics are nothing more than a simplification strategy we use to solve complex problems. So an example of a heuristic would be a ballpark estimate to solve a problem or a rule of thumb.
John Bryson:
Okay, representativeness, that's the heuristic. Can you give us an example?
Keith Van Etten:
Yeah, I'll give you a famous one. It's called meet Mary. So let me give you some information and you guess which response is correct. So growing up, Mary was an avid reader and eventually attended the prestigious university of California Berkeley. Personally, she is quiet, studious, and very concerned with social issues. So which of the following is most likely, (A) Mary is a librarian, (B) Mary's a librarian and a member of the Sierra club, or (C) Mary's a banker?
John Bryson:
Okay. So you said Mary's an avid reader, went to a good school, quiet, concerned about social issues. I'm envisioning; I'm envisioning a trick question here. All right, I know what I would say, what do most people say?
Keith Van Etten:
Well, most people choose B, which nearly two thirds do, followed by A, which is another one third, which leaves very few who answered it correctly, which is C, Mary's a banker.
John Bryson:
Okay, so you said B, she's a librarian and a member of the Sierra Club, because most people ... There's certainly more people working in banks than libraries, right? And certainly there's even fewer people who are working as librarians that are also a part of a certain club. I can see how people don't understand that and they're actually thinking of a probability-based question, but it's not the right way to work, right?
Keith Van Etten:
No, that's right. In this situation, our brain always seeks to create the most believable narrative with the information at hand. And in this case, if it looks like a duck and it quacks like a duck, it must be a duck. And this is a system one trait, and system one has a tendency to jump to conclusions and make speeding errors. So Mary is both a librarian and a member of the Sierra Club is probably the most believable, but it's also the least probable. So we make these mistakes all the time, we love a good narrative, especially when people are willing to connect the dots for us.
John Bryson:
Yeah. And I can imagine with narratives, it's all about the emotion and the information. I mean, we know there's no shortage of news and information on what's most probable to happen with the market, but not most probable. Certainly, when things are volatile and there's a lot of concerns going on.
John Bryson:
Let's go back to the coaching component for advisors and assume the advisor has successfully calm the investor down, walked him through the PAUSE, and they haven't sold out at the bottom. What are some of the behavioral tendencies or biases that an advisor should anticipate once the markets calm down?
Keith Van Etten:
Well, a real common one to look out for is what they call the anchoring and adjustment heuristic, and it relates to our tendency to grab onto a reference point, so really any piece of data that we'll subsequently use as a starting point to judge future satisfaction or potentially base a decision on as well. And that starting point becomes the anchor and then we make the adjustments from there, but really not far from there. So in that sense, it's similar to a boat that's anchored with a fixed length of line.
John Bryson:
Okay, so we're anchoring to a certain point, point of information, and adjusting from there. Give us a real-world example.
Keith Van Etten:
Well, a great example I think is a person's cost basis. If you think about two next door neighbors who live in the same identical homes. They were built the same year, same builder, both sellers are the same age, they're both going to retire to Florida, and they both decided to put their homes on the market at the same time. They use the same realtor, they both advise them to put it on the market for a million, and a buyer emerges and is prepared to bid 800 for either house, which seller is more likely to take the bid? It's a tough answer, right? But wait, let me give you a little bit more information. Now, seller A bought the house 15 years ago for $300,000. Seller B bought the house two years ago at a market top for 1.2. So now what do you answer? Well, behavioral finance would tell you that seller A is more likely to take the bid since they have the lower cost basis and would still realize a profit versus seller B who would realize a $400,000 loss.
John Bryson:
Yeah, I can totally identify with that—there's no way you'd want to take that loss even though you're talking, like you said, same house, same market, same everything. It's all where you start. All right, so that's anchoring. Let's relate it to investing in today's market. Bring it a little bit closer to home. Let's say an investor invests a hundred thousand last year, it's climbed steadily to 110,000 over a year and a half we'll say, but then the market corrects a situation that we'll see. Maybe the market corrects 20%. So their original investment of 100,000 went up to 110, is now down to $88,000. Clients may often anchor to that original investment amount, right? They said, "If I'm 88, if I can only get back to a hundred get back to even, I'm going to get out." Or they might anchor to that most recent high-water mark, "If I can get back to that point, I might get out" but that's not the long-term plan. The long-term plan isn't to invest at 100,000 and then get only to 110. We've got other goals and stuff that we need to pay attention to, right?
Keith Van Etten:
Well, exactly. It becomes more about the journey than the outcome and we want the goals-based outcome to be the focus.
John Bryson:
Yeah, I completely agree, the outcome—the goals-based outcome is the focus. All right, a couple of biases that we've already run through. What other biases should investors and advisors look out for?
Keith Van Etten:
Well, another one is the effect heuristic and it's perhaps the most powerful of all the biases and heuristics that research has identified simply because it's visceral; it's automatic; it's decisive. Paul Slovic, who's the professor of psychology at the university of Oregon, he's also the president of decision research, he's written extensively about the effect heuristic and he defines it as the specific quality of goodness or badness, experiences a feeling with or without consciousness and demarcating it positive or negative quality of a stimulus. So in a nutshell, with little thinking or analysis, we can quickly express a preference when presented with really simple options based on just basic feelings of like and dislike.
John Bryson:
So we're going to naturally have a gut reaction to almost any opportunity that's presented to us, it sounds like. So how's that impact investing?
Keith Van Etten:
Well, we feel that many retail portfolios we've reviewed may not be as diversified as they could be from a risk perspective, whether it's diversifying internationally or even using alternatives.
John Bryson:
Okay. Why so?
Keith Van Etten:
Well, retail portfolios tend to look much different than institutional portfolios, partly due to client preferences for things they know and understand. A study by the same gentleman Paul Slovic in 1994 found an inverse relationship between perceived risk and perceived benefit based on someone's level of familiarity or favorability about something. Why? Again, because people base their judgements of an activity or even a technology, not only on what they think about it, but more importantly, what they feel about it. If they like something, an activity or a product, they're moved to judge the risks as low and the benefits as high. And if they dislike it, they tend to do just the opposite, they tend to associate a higher risk and a lower benefit. And things like alternatives and international markets are less familiar to retail investors, which is one reason why they tend to hold less of these than institutional investors.
John Bryson:
It makes a lot of sense. Certainly, the thinking it through versus feeling it through and the complexity, if it's more complex, it's going to be a bigger issue. In the case of alternatives, many had been disappointed with their performance during the bull market, but clearly there's more to it than that. Maybe they're confusing complexity with risk on some level.
Switching gears, let's close by talking about investors in their aversion to loss, but from a different perspective, let's look at a go-forward perspective. There's a natural behavioral tendency towards being conservative and I would imagine sustaining losses doesn't change that, but there's a risk to being too conservative too, right?
Keith Van Etten:
There is. The classic mistake is you ride the market down and then you go to cash and you miss the eventual rebound and frankly, that can send your portfolio on an entirely different trajectory that can add years to the recovery time. The time to be thinking about risk management is when the sun is shining, not at the bottom of the market. And we tend to be risk averse when we should be thinking about risk seeking and vice versa.
John Bryson:
Great point. When we're talking to advisors, we try to counsel that a good practice is to have a written plan and write it with the client, almost like a contract between the two of you that you can refer back to you in times of emotion. We know emotions are going to get in the way. You want to establish steps that you will and won't take during periods of volatility when you're not in those periods of volatility, right?
Keith Van Etten:
No, that's right. For example, you can agree the dollar cost average into these downturns with any available cash. It's important that they understand that corrections of 10% or more are very common and bear markets are always inevitable. And if they can develop confidence that the markets will eventually bounce back, then they can view these periods of volatility as opportunities to upgrade their portfolios. And really this is where communications is critical. The more you can prepare them in advance, the less adverse the reaction is likely to be. And Cerulli did a study not long ago that showed a common trait of the highest performing teams was the frequency with which they met with their clients. It showed that 48% of top core tile teams met with their clients on a quarterly basis and that was nearly twice as high as all the other teams, so communications is critical. We'll just leave it there.
John Bryson:
That's great information, Keith. Very much appreciate it. So to summarize: We need people to recognize that under stress, your brain is wired to focus on survival, but it's not the optimal state to make logical, long-term decisions. That doesn't mean throw more data at the problem and that instead advisors, they should help their clients pause, i.e., shift from system one thinking to system two thinking, by empathizing with their clients, help them see the differences of what is probable versus plausible. And this takes a lot of patience and coaching, so coaching—so please be patient. We recognize that there are some strong biases at play here, lots of versions of strong bias, anchoring, pricing one reference point, getting back to even that's a strong bias. People we know equate complexity with risk. That's the effect heuristics so be aware of that because sometimes the more complex option, like international stocks or alternatives, might be the better option. It can actually reduce risk in a portfolio.
Remind your clients that their portfolios will go down at times. Have a written plan, recognizing all those emotions that will take place that want to force you away from your plan, but you want to have a logical course forward. It's critical to establish that plan and those steps that you'll take in a crisis before you are actually in the crisis. Make sure that you both agreed upon and refer back to that plan frequently. We mentioned that dollar cost average is a great option when a market's in turmoil and we want to remind people and advisors specifically stay in regular and proactive communications with your clients.
Well, that's all we wanted to cover today. If you want to hear more about what we have to offer, please subscribe to the Portfolio Intelligence podcast on iTunes, or visit our website, jhinvestments.com, to read our viewpoints on macro trends, portfolio construction techniques, business-building ideas, and much, much more. Thanks for listening, everyone.
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