I was reading an article about Dennis Gartman, a newsletter writer, professional trader, and frequent guest on CNBC. According to Financial Advisor’s story, “A risky crypto bet dented Dennis Gartman’s retirement account.” “Crypto,” of course, refers to cryptocurrencies, which are based on “blockchain” technology—with the best known “currency” being bitcoin. Gartman reportedly told CNBC less than two months ago that bitcoin “is nonsense.”
While the details of Gartman’s trade are unimportant, he wrote in his newsletter, “Friday was one of the worst days we have suffered through in a very long while. … Lessons have to be learned again and again and again it seems. Or at least we apparently have to learn them over and over and over again.”
Behavioral bias doesn’t just impact retail investors
I recently wrote about the growing prominence of behavioral finance theory in the investment world and explored some common behavioral biases for self-directed investors.
But what about financial advisors and other investment professionals? Are they similarly affected by biases? (Gartman’s story appears to be one such example.)
As the editor of Proactive Advisor Magazine, I have interviewed successful financial advisors from all corners of the United States. Virtually all of these financial advisors subscribe to a very disciplined financial and investment planning process for their clients.
But many will freely admit to having made some past mistakes in investment judgment, process, or implementation. And research studies document that almost every textbook example of behavioral finance bias or emotional decision-making could be ascribed to financial advisors and other industry professionals at one point or another in their career.
A 2015 article from the CFA Institute (home of the Chartered Financial Analyst credential) pointed out,
“Heuristics—mental shortcuts—and other biases continue to affect some of our professional choices, leading us to make mistakes. For a gifted few in the industry, biases are a source of alpha. But for many others, biases impose a cost—a price paid for irrationalities. Financial markets reflect these irrationalities and collective biases.”
Three of these behavioral biases, I think, stand out from my discussions with many financial advisors.
- Trend-chasing bias. Today’s financial advisors have access to institutional-type strategies built with sophisticated algorithmic models by third-party investment managers, which is a real plus for their clients. But the advisor still must make fundamental portfolio allocation decisions. Unfortunately, on occasion, the advisor may “chase” the best-performing strategies of the previous quarter or year.
As one representative of a prominent third-party investment firm recently said,
“One experience advisors may have had is choosing to use a back-tested strategy for client portfolios after it had a good and long run upward. We often watch strategies do well and then attract a large amount of assets due to their recent success. There is nothing inherently wrong with that. However, such strategies then might experience a period of sideways or drawdown performance. That normal, yet less-than-stellar, performance leads performance-chasing advisors (or their clients) to quit the strategy before the next period of positive performance.”
A diversified portfolio of several different actively managed strategies that are not highly correlated, he says, can offer advisors’ clients higher probabilities of success over the long term and throughout bull and bear market cycles.
- Familiarity bias. Like retail investors, some financial advisors will naturally have an inclination to stick with the familiar. It is important for advisors to continually educate themselves as to new strategic offerings, weighing not only the pros and cons of each strategy for their clients but also how each one might fit as part of a dynamic, risk-managed portfolio of strategies.
- Herd mentality. This can manifest itself in different ways for financial advisors, most often prompted or reinforced by the behavior of their clients or their peers. In today’s long-running bull market, clients tend to become more return-oriented in their expectations as the market continues (until quite recently) to make new high after new high. Although these same clients may have explicitly agreed to an investment plan that was well-aligned with their risk profile and incorporated several strong elements of risk management, their devotion to a disciplined approach may start to waver in the face of a rising market. Advisors need to continually reinforce the long-term benefits of an actively managed approach that will mitigate risk when the market inevitably turns around or goes through bouts of volatility.
In 2015, the CFA Institute conducted a survey of its professional readership asking their audience to select the behavioral bias that “affected their investment decisions the most.”
These types of biases, most experts agree, tend to be most pronounced at market extremes. Investors of all types are more prone to take on too much risk in elevated markets and are susceptible to making poor decisions in highly volatile or declining markets. Nobel Prize–winner Richard Thaler has remarked, “Investors make mistakes—and they make mistakes because they are human.”
The good news is that the time-tested, quantitative strategies can help take human emotion out of investment decision-making, both for financial advisors and their clients. They have been designed to perform competitively during bull market environments and to manage risk in hostile markets—responding to market conditions through full market cycles.
Quick market recap
The robust rally on Friday (2/23) turned what looked to be a losing week into a modestly positive one. Friday’s gains of 1.6% on the S&P 500, accompanied by similar strong results for other major indexes, helped the SPX to an overall weekly increase of 0.6%. That index has regained more than half of the losses of February’s pullback and, through Friday’s close, was down less than 5% from its all-time intraday high. The SPX was up just under 3% for the year at Friday’s close. Volatility moved lower, despite a week with some major market moves, and the VIX (CBOE Volatility Index) ended the week just over 16. A modest retreat in the U.S. 10-year Treasury yield helped equity markets book gains on the week, with the 10-year finishing last week at 2.87%.
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