Why Advisors Need To Measure Regret

Nobel Prize-winning behavioral economist says financial advisors must understand what loss aversion does to investors.

Reviewed by: Cinthia Murphy
Edited by: Cinthia Murphy

Nobel Prize winner Daniel KahnemanFinancial advisors have many tools at their disposal to help them build and manage their practices as well as build and manage portfolios.

They often lack, however, what’s perhaps the most important tool of all: an understanding of what drives investor decisions.

That’s significant in a time when fintech innovation and algorithmic investing is growing, and advisors scramble to reassert their value proposition to clients. Most of them have no psychology training and lack any sort of industrywide guideline on how to navigate the impact behaviors have on investing decisions.

Strong Loss Aversion Is Real

Nobel Prize-winning behavioral economist, and author of the book “Thinking, Fast and Slow,” Dr. Daniel Kahneman tackled this topic at the Morningstar Investment conference in Chicago on Tuesday. To Kahneman, the key is to offer clients advice “they can live with.” To that end, advisors need to understand the strong loss aversion most investors—even very wealthy ones—tend to feel.

“Regret minimization and profit maximization are different things,” he said. “My primary guideline to addressing this is what I call ‘broad framing.’ You want to take a broad view [of the client’s financial life] and balance what they’re worried about with what they want.

“Not everyone is going to get the same advice,” Kahneman added. “The optimal allocation for someone who’s prone to regret and for someone who’s not prone to regret are not the same. And the most profit-maximizing allocation isn’t always the right solution.”

What Makes Clients Leave

This focus on loss aversion as a measure of regret serves to inform advisors of what types of scenarios would cause their clients to bail out on their portfolios and on the advisors themselves.

This understanding is the crux of a financial advisor’s value proposition today, particularly as technology takes over other aspects of the business.

“When bad things happen, there’s a hand-holding function that’s very important,” Kahneman said. “People need to have a sense that there’s someone they trust who knows what they want and understands the feel of what they’re going through.

“Regret attitudes are very important to measure,” he noted. “Discussing with clients what can happen and what it can mean to their portfolios allows clients to make an informed commitment to the advisor, and not go looking to change advisors every time something goes wrong.”

Two-Portfolio Approach

One of his most practical suggestions? Offer two portfolios for every client: one designed with risk aversion in mind; and one where investors can embrace risk without worrying about their overall financial health. It’s a model Kahneman has seen implemented successfully before—two separate portfolios—one safer, one riskier—that are managed separately, and offer clients results separately.

“That solution allows people to be comfortable with the amount of risk they’re taking,” he said. “It’s all about reducing the risk to a level you’re comfortable with.”

This is obviously more of a psychological solution than a truly financial one to manage investors’ fear of loss in investing. At the end of the day, two portfolios are still drawing from the same assets an investor has.

But it goes to show that how people feel about their investments is just as important as number crunching and performance. Many behavioral economists such as Kahneman or the likes of recent Nobel Prize winner Richard Thaler have banked their careers on that.

Contact Cinthia Murphy at [email protected]

Cinthia Murphy is head of digital experience, advocating for the user in all that etf.com does. She previously served as managing editor and writer for etf.com, specializing in ETF content and multimedia. Cinthia’s experience includes time at Dow Jones and former BridgeNews, covering commodity futures markets in Chicago and Brazil equities in Sao Paulo. She has a bachelor’s degree in journalism from the University of Missouri-Columbia.