Homer’s Odysseus used his intelligence to avoid a whirlpool and a man-eating monster. Today’s advisors are smart too. They know that capturing some upside while protecting against the downside can manage client emotions and avoid “being stuck between a rock and a hard place.”
Ever since the Odyssey—for at least 3,000 years—humans have struggled in seemingly no-win situations. Odysseus relied on his own skill to navigate his challenges, but financial advisors can get extra help today from the field of behavioral finance.
Behavioral finance originated with Daniel Kahneman’s explorations in the 1970s. Thanks to his research, we know that the human brain creates investment problems by misunderstanding how the world works. We’re also aware of decision-making vulnerabilities built into our brains, thanks to Kahnemann’s 2011 book, Thinking, Fast and Slow.
Loss aversion is one of these vulnerabilities.
Loss Aversion Blocks the Path
Many advisors believe we’re in the late stage of the current economic cycle. Valuations have crept up, leading some to believe we’re overdue for a correction. Advisors know clients will be unhappy when their portfolios’ value takes a dip. But they also recognize that clients will get angry if they miss any of the market’s buoyancy.
So, advisors are caught between their own rock and a hard place. If an advisor takes a defensive posture (deploying capital into “safe” strategies) and markets rise, his clients feel betrayed. They perceive the missed gain as a loss because their brains compare the actual investment returns with the potential gains.
These emotions are strong. Kahneman’s research revealed that losses are perceived about two and a half times more intensely as a negative feeling than the same amount of gain is felt as a positive. He labeled this feeling loss aversion, which magnifies the intensity of clients’ feelings about their investments.
Here’s another obstacle: Clients tend to assume that next year’s returns will be basically the same as last year’s. Kahneman calls this behavior inappropriate extrapolation. When the advisor suggests it may be time to become a bit more defensive, the client’s loss aversion is activated, and she may feel as if next year’s expected returns are being taken away.
No one has been able to reliably predict exactly when a market correction is about to happen. There’s no early warning system to enable advisors to time their exit. This means the prudent advisor is stuck: either stay fully exposed to the upside potential of the markets and risk clients’ anger when markets tumble, or protect clients from a potential correction and face their frustration. Fortunately, an active manager can offer a third option, effectively avoiding the rock and a hard place.
Riding the Tide
In recent years, some managers have focused on the ratio between upside capture and downside capture as a way to improve investor outcomes across the full market cycle.
Unlike the growing number of passive investment solutions that are exposed to less than 100% of the upside of the markets and more than 100% of the downside, capturing some of the upside return while protecting against most of the downside risk allows the investor to enjoy a better path of returns.
Late in the cycle, it’s especially helpful to look at the upside/downside capture ratio of an investment strategy—especially when clients are reluctant to give up the gains they expect in the near future. A strategy that offers much of the potential gain while protecting against even more of the potential loss allows you to fulfill your ultimate responsibility as an advisor.
That responsibility is to provide your clients with your best professional thinking about what is in their personal best interests (despite what their emotions may be telling them).