Psychology is Key to Investing, says Nobel Prize Winner

Daniel Kahneman explains how tools such as using "regret proof" planning can lead to better investing

Morningstar News Team 18 June, 2018 | 2:20PM
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The Investing Brain

Finding out how people tick is a vital part of the investment process, Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow, told the 30th annual Morningstar Investment Conference in Chicago.

He had this advice for financial advisers hoping to steer clients towards reaching their investment goals: "You need to find out what the client's dreams are, what their fears are. And when bad things happen, you need to be there to help people stay on course."

Kahneman, speaking with Morningstar behavioural scientist Sarah Newcomb, said that in  in investing, research on behavioural biases can be used for good or evil. In the worst case, these biases could be used to exploit clients. In the best case, they could help a client develop and implement their financial plan and potentially improve their outcome

The first step is to decide what's in the client's best interest, Kahneman said. Then the adviser needs to find some way to develop a "regret proof" policy – a policy someone can live with when things go badly. This reduces the chance that a client will capitulate at the wrong time and possibly move to another adviser.

Kahneman described a practice he had developed with colleagues to improve investor outcomes. First, the adviser would try to determine the client's loss aversion to create a measure of projected regret.

"We try to have people imagine various scenarios. We ask them, at what point do you think you would want to bail out?" There are some differences, Kahneman says, but he has found that even extremely wealthy people are loss-averse.

Two-Part Portolios to Manage Risk

The next step was to run client portfolios in two parts. One portfolio holds the assets the client is willing to risk, and the other is a much more conservative portfolio comprising what the client wants to protect. The portfolios are managed separately and clients get the reports individually. 

This is helpful for clients because no matter the market environment, one of the portfolios is likely doing well. Of course, financially, it's one portfolio, but framing it as two separate accounts helps clients understand and tolerate the risks better, he explained.

Asset allocation, in many ways, is the easy part. Helping clients set reasonable goals and adhere to their plan is the difficult part; it requires having in-depth, sometimes personal conversations with client. One element of the process taking a comprehensive look at the client's present and desired future outcome.

"Individuals tend to do very poorly guessing what stocks will do. Admitting you don't know is a very healthy step, but this admission leaves you with a great deal to do," he said.

Advisers should be realistic with investors about the potential outcomes, Kahneman said. They need to help clients make informed decisions. By discussing the risks in advance, advisers are preparing them for what could happen. 


The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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