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Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope

Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope. Meir Statman Glenn Klimek Professor of Finance Santa Clara University http://lsb.scu.edu/finance/faculty/Statman/Default.htm. January 1997. The Story of Sharon and Russ Gornie Hopes and Fears.

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Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope

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  1. Promoting the wealth and well-being of your clients: Managing risk, regret, fear and hope Meir StatmanGlenn Klimek Professor of Finance Santa Clara University http://lsb.scu.edu/finance/faculty/Statman/Default.htm

  2. January 1997

  3. The Story of Sharon and Russ GornieHopes and Fears

  4. Gornies Clip Here

  5. Standard Finance and Behavioral Finance Standard Finance – Investors are rational. Behavioral Finance – Investors are normal.

  6. We are neither rational nor irrationalWe are normal We know Sharon and Russ. We know their hopes. We know their fears. We know their aspirations. Can we help them?

  7. What do normal investors want? It is about more than money. It is about more than risk and returns. It is about: hope fear winning stress status security It is about: life

  8. Financial Physicians Physicians promote more than health. They promote health and well-being. Financial advisors are financial physicians. The promote wealth and well-being. Financial advisors manage investments. Financial advisors manage investors.

  9. Financial Physicians Ask, listen, empathize Diagnose Educate Treat

  10. First Lesson to investors and advisorsKnow Yourself Make yourself your ally Know your goalsKnow your emotionsKnow your cognitive biases

  11. Second Lesson to investors and advisors Protect Yourself Make science your ally Know the science of financial markets.Know the science of human behavior.

  12. Third Lesson to investors Protect Yourself Make your financial advisor your allyGood financial advisors are like good physicians. They educate and sometimes they nudge. Good financial advisors promote both wealth and well-being. Third Lesson to advisors Be a good financial physician

  13. Cognitive Biases and EmotionsRome Airport

  14. Cognitive Biases and EmotionsRome Hotel

  15. Cognitive Biases and EmotionsRome Hotel

  16. Cognitive Biases and EmotionsRome Hotel

  17. Cognitive Biases and Emotions Cognitive biases • Framing • Size and color of Euro bills • Mental accounting (Where do the €80 belong?) • Hindsight • Emotions • Embarrassment • Anger • Regret

  18. Cognitive Biases and EmotionsHow can we overcome hindsight?How can we make peace with losses? The pain and the phantom pain of regret.

  19. Cognitive biases and emotionsRegret Investors overcome the pain of regret by shifting responsibility. I am not stupid. My financial advisor is stupid.

  20. Financial advisors are tempted to strike back. “If we’re being honest, it was your decision to follow my recommendation that cost you money.”

  21. Cognitive biases and emotions Hindsight and regret Google Cikovsky took $4,000 cash. Patterson took 16,000 stock options. 16,000 Google shares @ $85/share = $1,360,000 @ $300/share = $4,800,000 @480/share = $7,680,000

  22. Cognitive biases and emotions Hindsight and regret. Why didn’t I get my $4,000 in Google options?

  23. Make science your allyCombating cognitive biases and emotionsEducation (We are all subject to hindsight bias and regret) Cikovsky: Do I wish I’d had the shares? Yes…but what’s always in the back of my mind is an IPO is never guaranteed…and 9 out of 10 start-ups fail”

  24. Make science your ally Evidence – Based Medicine Theory, hypotheses, and empirical evidence Wheat Bran Dietary Supplement Appears Not to Reduce Risk for Developing Pre-Cancerous Colorectal Polyps. New England Journal of Medicine (2000)

  25. Make science your allyThe science of human behavior But why do we behave as we do? Because we are intelligent We search for patterns We jump to conclusions We are affected by emotions We fall into pitfalls of cognitive biases

  26. Evolutionary PsychologyDarwinian Psychology Why is intuition so appealing? The scientific method as a check on intuition A brain module for recognizing faces

  27. Recognizing faces clip here

  28. Of Rats and Men.Who is more intelligent?

  29. S B Intelligence - Searching for Patterns Touch a button, S or B You win (money or food) if the choice is right.

  30. B S Intelligence - Searching for Patterns Touching Button S 1/5 chance of winning Always 100% Rats 4/5 80% Men 4/5 chance of winning 60% 40% Make science your ally Are the patterns you see really there? 20% Never 0% 1 2 3 4 5 Time

  31. Portfolios and Asset Allocation

  32. Question If you could increase your chances of having a more comfortable retirement by taking more risk, would you: • Be wiling to take a little more risk with all your money? • Be willing to take a lot more risk with some of your money?

  33. A lot more risk = x Some of your money Addition to portfolio risk = x All of your money Addition to portfolio risk A little more risk Money Risk a. If you could increase you chances of improving your returns by taking more risk, would you: b.

  34. Mean-variance portfolio theory Investors care only about risk and expected returns. Investors are averse to risk. Investors consider portfolios as a whole.

  35. Mean-Variance Portfolio Theory

  36. Investors are not always averse to riskInvestors buy both insurance policies and lottery ticketsInvestors are motivated by goalsInvestors consider their portfolio as a pyramid of distinct layers, not as a whole Behavioral Portfolio Theory

  37. Mean-Variance Portfolio TheoryIt all mixes in the stomachInvestors want highly nourishing and low cost meals. Behavioral Portfolios Portfolios from the perspective of the palate as well as the perspective of the stomach. Investors want highly nourishing and low cost meals. But they also want palatable meals.

  38. Satellite Core Behavioral portfolio theory A LOT more risk with SOME of your money

  39. Satellite Core Behavioral Portfolio Theory Downside protection vs. Upside potential? Low risk vs. high risk? (Risk budget)Passive vs. active?Diversified vs. concentrated?

  40. Behavioral Portfolio Theory

  41. Charity Travel Children’sEducation Retirement Behavioral Portfolio Theory

  42. I have some chance of upside potential (20% chance) I’m virtually sure that my downside is protected (Almost 100% chance) Behavioral Portfolio Theory Different probabilities for different goals Financial advisors should create portfolios that distinguish downside protection from upside potential and offer sure downside protection along with some upside potential.

  43. Behavioral Portfolio Theory Focus on goals

  44. Behavioral Portfolio Theory Goals, hopes, fears and aspirations change over time Late 1990s Someone’s going to win the lottery. Just not you. It’s time for E*Trade

  45. Behavioral Portfolio Theory Goals, hopes, fears and aspirations change over time Early 2000s

  46. Behavioral Portfolio Theory Goals, hopes, fears and aspirations change over time Late 1990s Early 2000s Upside Upside Downside Downside

  47. Financial Physicians Aspirations Investors aspire to be rich. (Greed) Investors aspire to be secure. (Fear) Don’t let your investors fluctuate between greed and fear. Don’t let your investors fluctuate between lottery tickets and money market funds Financial Physicians promote wealth and well-being

  48. Make science your ally Emotions affect attitudes toward risk FearTake less risk

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