Wise decision-making is essential to helping clients manage their portfolios. Daniel Kahneman, the 2002 Nobel Prize winner in economics and the author of the best-seller Thinking, Fast and Slow, tells contributor Michelle Lodge how both emotional and deliberative thinking figures into the client-advisor relationship.
1. Tell us. What is "fast" thinking?
Fast thinking is the first impulse that comes to your mind-an emotional reaction to something that is attractive or unattractive. Here's an example: Many years ago I visited a chief investment officer of a large financial firm, who had invested tens of millions of dollars in shares of Ford Motor Company after having been to a car show. I found it remarkable that he had apparently not considered whether the Ford stock was currently underpriced. Instead, he listened to his intuition, or fast thinking: He liked cars, he liked the company and he liked the idea of owning its stock. In investing, the best attitude to have is one that mutes the emotional.
2. Is "slow" thinking better for advisors now when markets move on information generated by the nanosecond?
There are forms of trading that are very rapid, but I'm not sure that they are faster than they used to be. Slow thinking is the reason clients use financial advisors: It helps them keep their heads and not panic when making decisions about what to invest in and when to hold and sell stocks. The spontaneous, or fast, search for an intuitive solution sometimes fails. In such cases, we often find ourselves switching to a slower, more deliberate and [laborious] form of thinking.
3. How can advisors prepare clients for the ups and downs of the market?
It's extremely important for advisors to anticipate how clients will react to different situations, whether it's to losses or buying or selling, by having that conversation with them in advance. I worked as a consultant to Guggenheim Partners on what advice to give very wealthy clients who are adverse to losses and prone to regret. Some clients react much more strongly to loss than others, so advisors need to prepare them and then work with them should losses occur.
4. What are the outcomes for investors who trade frequently and for those who are more deliberative in their investing habits?
Many individual investors lose consistently by trading often. Terry Odean, a finance professor at UC Berkeley, tracked the trading records of 10,000 brokerage accounts of individuals over seven years, specifically those individual stocks they sold and bought to replace them. The results were unequivocally bad. On average, the shares that individuals sold did better than those they bought by a substantial margin, 3.2 percentage points a year, [which was] above and beyond the large costs of executing the two trades. Of course, these results are about averages. Some investors do better than others. However, for a large majority of investors, taking a shower and doing nothing would have been better than implementing the ideas that came to their minds. This is where an advisor can help emotional clients make better decisions.
5. What role does overconfidence play?
The general stereotype is that more men than women tend to be overconfident, and by feeling overconfident, men tend to operate more often on their impulsive thoughts. Women do better because they do less churning of their portfolio. In "Boys Will Be Boys," a paper by Odean and colleague Brad Barber, they showed that men acted on their useless ideas significantly more than women, and that, as a result, women achieved better investment results than men.