Why Your Grandmother Was Right

My grandmother always had something witty or wise to share. One of her favorites had me imagining vivid pictures of pounds of medicine in bottles and spoonfuls of colorful liquids.

Imagine my surprise when I studied behavioral economics and learned that the ratio of prevention to cure when it comes to working with distressed clients is the same as ounces to pounds: 16 to 1.

The Problem with Loss Aversion

The insight into this ratio starts with Daniel Kahneman’s research into loss aversion. Kahneman described how people feel loss about two and a half times more strongly than gains. This finding was instrumental in revealing why humans don’t consistently make rational decisions. It led to dismissing the simple mathematical models that prevailed in the early days of economic research and turning to a more complicated model, driven by numerous discoveries of hardwired mental shortcuts—which Kahneman called heuristics—dominating the way people make decisions.

These insights have made their way to the awareness of client-facing financial advisors. Rather than assuming clients can cope creatively with volatility in their investments, wise advisors are sensitive to the emotional reactivity their clients will have when markets trend negatively. Rather than being surprised when clients become emotional, advisors can help clients who are upset and by preparing to handle those conversations more artfully.

Why 16:1 Is So Important

Behavioral economics teaches that negative emotions are far more significant for survival than positive ones. This is the essential meaning of loss aversion: it’s more important to protect yourself from negative experiences that can hurt or kill you than to seek out positive experiences that will benefit you. Life is asymmetrical.

There’s a second aspect that is significant for our discussion. It concerns the way the human brain functions: as an information storage and prediction machine. Because life is challenging and threats are numerous, our brains are wired to retain essential learnings from past experiences and use those patterns to predict future outcomes. In this way, the brain works to preserve life in a threatening environment.

Observations of human experience reveal an interesting dimension to this function: when a prediction fails, the brain becomes distressed. A surprise represents a breakdown in the brain’s ability to predict the future. As a result, a surprise typically magnifies the significance of an experience. This magnification greatly increases how someone reacts to an unexpected event. This has substantial implications for working with clients.

Can you remember a time when you were pleasantly surprised by something that happened in your life? Perhaps someone threw you a party or your boss gave you a larger-than-expected bonus. The surprise made the event even more positive.

Positive events are not the only experiences that can be magnified. This is another expression of the asymmetry of loss aversion: surprising negative experiences are much more painful than anticipated negative experiences.

What Does This Have to Do with Being a Financial Advisor?

As we have seen, the thoughtful advisor anticipates that clients will become upset when markets trend downward and is prepared to have hard conversations. Unfortunately, if she allows a client to be surprised by negative events, the level of emotional distress may exceed what the client can tolerate and what the advisor can manage. The combination of loss aversion and an unexpected event magnifies the client’s experience of pain.

So, the prudent advisor not only prepares to have hard conversations when markets become volatile but also helps her clients anticipate what is likely to happen in the future by having conversations when economic signals indicate potential volatility.

This is why my grandma’s advice is backed by science: an ounce of prevention in the form of conversations that anticipate impending volatility is worth pounds of more difficult conversations after the fact. To the extent possible, the skillful financial advisor never allows her clients to be surprised by the markets.

Upcoming Webcast: Managing the Hard Conversation: A Four-Step Process for Defusing Emotional Clients

Register for our next practice-management webcast on May 11^th. Ken Haman will map out a simple four-step process for advisors use with clients to help diffuse irrational thinking and restore thoughtful decision-making.