Being of two minds, one rational and one emotional, sets us up for some painful challenges.
In spite of good intentions, people keep smoking even when they know it is bad for them and they say they want to quit. In the same way, many people continue to use UV tanning beds, even when there is compelling evidence that UV exposure significantly increases the likelihood of skin cancer. In each case, a rational person decides to do something that is clearly bad for him and that he knows, rationally, he should avoid. Why?
The answer is more than that it is just human nature. It has to do with the sequencing of pleasure and pain. Many (if not most) human beings struggle with doing the right thing even when they know what the right thing is.
Managing behavior has to do with how vividly and realistically a person projects the mental images of future negative outcomes. Without such vivid mental images, most of us will wait until there is a compelling reason to act before doing so. Remember when you were in school and got an assignment to write a long paper; when did you start? Why are there long lines at the post office at 11 p.m. on April 15?
There is a parallel in the financial-services world. As a practice management strategist who works with advisors every day, I help advisors understand why investors arent repositioning themselves for a rising interest-rate environment. Unfortunately, the advisors who are actively grappling with the importance of this issue seem to be in the minority, at least among the people Im talking to. Here at AllianceBernstein, we are very concerned that many advisors arent dealing with the negative outcomes that are possible in the near future. Few advisors are encouraging their clients to take action now and prepare for the challenges their investments will face in a rising interest-rate environment.
Of course, Im not calling the market when I suggest that rates will be rising. Investors know that interest rates are at or near historic lows. Rationally we know that, eventually, rates are going to rise. After 30 years of falling interest rates, it isnt surprising that we are avoiding the negative thoughts about tomorrow.
Its comforting to hope that things will stay as they are. Unfortunately, comfort is not a strategy. As advisors we know that when rates rise, taxable and tax-free bond portfolios are going to be deeply affected. We can even shock-test portfolios and determine how much they will be affected at varying interest rates. But this kind of rational thinking doesnt motivate most people. As understood and predictable as these future negative outcomes are, they havent happened yet. They are still safely out there in the future. We are still enjoying the benefits of the low interest rates and high premiums in our bond portfolios.
The most common response I hear from advisors when I raise a concern about preparing for the inevitable is, When you think the Fed is about to raise rates, give me a call and well talk about our options. They seem to be waiting for a bell to ring before rates shift so that they can make an orderly adjustment to meaningful investment alternatives.
Mental Exercise for Advisors
Just like smokers and dieters and owners of beachfront real estate, these advisors are waiting for some compelling signal to tell them it is time to take action. They look to financial analysts, media experts and industry spokespeople to fire the starting pistol. This is just like waiting for April 14 to arrive before starting tax preparation. Unfortunately, in this case there isnt a calendar to warn us that the deadline is approaching. When it comes to rates, once they start going up, its a bit late to prepare.
Consider this mental image: many people are trying to buy generators and the clerk suddenly shouts, We only have two generators left; first come, first served! Or imagine being in line at the post office on April 15 and the postmaster says, Were closing in five minutes. Or even worse, imagine a doctor saying, Your weight problem has caused Type II diabetes.
The prudent advisor understands that there are two times to talk with clients about a rising rate environment and repositioning assets: before rates rise, when clients are rational and you still have flexibility, or after rates rise, when clients are upset and your options are diminished (or disappear entirely). When do you think is the better time to make some strategic decisions and have some heart-to-heart conversations? Importantly, what bad thing will happen to you if you are a bit early with your concern?
Mental Exercise for Clients
Have you seen pictures of cancer victims published as part of antismoking campaigns? These pictures have been shown to impact the thinking patterns of people who have pushed off their concerns about health into the future. The pictures work because they bring future outcomes into the present; they make a fuzzy future picture real and immediate.
When it comes to working with clients who want to push off decisions about their fixed-income investments, it is helpful to use the same strategy: make those future dangers vividly clear now. This shouldnt be just a rational conversation about ideas; you should include an appeal to the emotional side of each client as well. With investments, this can be done with a simple strategy: show clients in real dollars how much money they will lose under several interest-rate scenarios. The real-dollars description is an important part of this strategy, as the dollar figure tends to make the losses real, while a percentage mutes the impact. Which seems more impactful: a 10% loss on a $1 million portfolio or losing $100,000 on a bad investment?
The key to getting clients to act now is to make the future negative outcomes of a rising rate environment vividly real, and then to offer a meaningful alternative investment as a way to avoid that experience. We recommend that all advisors take a thoughtful approach, have the courage to advise and take the time to show clients how making changes within their portfolios can provide some protection from rising rates.
While there is some reason for urgency, we arent suggesting that you rush out and talk your clients into making an impulsive change in the way you manage bonds. Only you can decide what the right alternative is for your clients and business. What we are recommending here is a proactive strategy of engagement: explain the problem, offer solutions and show consequences associated with not acting. Importantly, we are urging you to err on the side of being cautious and early, rather than waiting for a signal that may not come.
Physician, Heal Thyself
I mentioned earlier that I live in Florida. Shortly after I moved there and well outside of hurricane season, I spent several days cutting thick pieces of plywood to cover the exposed windows in my home. This was a lot of effort, but I was concerned that a hurricane may come in the future. What motivated me? Right after we moved in, I had several conversations with people who shared vivid experiences of hurricane damage and the challenges of getting repairs done when everyone else in town was also trying to find a contractor.
Those images haunted me and pushed me to drag chunks of plywood home from the lumber yard and fit them into each window opening. When I was done, I felt relieved and much safer, and those images faded from my mind.
But as I write this, I realized I never got around to buying that portable generator. Time for another trip to the home improvement store.
Ken Haman is the Managing Director at the AllianceBernstein Advisor Institute, visit http://ria.alliancebernstein.com.