After graduating from the University of Victoria with his B.A., Brad traveled throughout Asia and settled in Taiwan in order to study Chinese at the National Sun-Yat Sen University. After returning from abroad Brad got his full life license in the summer of 2004 and his mutual fund license in early 2005. After two additional years of studying, Brad ascertained his full Certified Financial Planning designate in 2007. Brad is currently a senior partner and co owner of Bumstead Financial Services , an independent financial planning firm with offices in Vancouver and Calgary. Brad can be reached at [[email protected]]
Bradley Bumstead, BA, CFP is currently a senior partner and co-owner of Bumstead Financial Services
Risk management is an important element of any financial plan. We often speak of currency risk, capital risk and liquidity risk. We diversify our holdings to protect from financial risk, market risk and inflation risk. However one of the least considered and prepared for types of risk is behavioral risk. I am referring to the personal emotions that come into play with the ups and downs of the market. This is usually never more evident then at the peak of a bear or at the trough of a bull market. With increased volatility comes an increase in the personal emotions and beliefs associated with investing.
I recently attended a presentation by Doug Towill on Mindful Investing and how to avoid common investment mistakes. Doug was speaking about investor behavior and how emotions often lead investors to make reactionary decisions without thought or concern for previously established commitments. Decisions are made for purely emotional reasons (usually greed or fear) without any thought being given to their true intentions when these positions were entered into in the first place. DALBAR, an independent research firm, recently updated it’s Quantitative Analysis of Investor behaviour (QAIB) study and found that while the S&P 500 index has returned 8.35% over a 20 year period ending in 2008, the average equity investor earned just 1.87%, which was less than the inflation rate of 2.89%. The same held true for bond investors (actual returns of 0.77% compared to 7.43% for the index). The QAIB study has consistently shown a large gap between the returns investors actually earn and the returns they could have easily earned with a buy and hold strategy. This was certainly due to investors making snap decisions as a reaction to market conditions. I was amazed to see the amount of negative impact that an emotion driven decision can have on an investor’s long term returns and overall financial health. I also must admit that I understand why these decisions are often made. As humans beings we are programmed to be emotional and act upon those deep rooted feelings. It is not in our nature to ignore those bouts of fear, love, pride and greed that call us to action. These are great things and lead to the majority of great moments in life, however within financial planning we strive to reach our decisions in an objective manner with an overall understanding of how those decisions affect us over the long term. Is it possible that you may be one of the greatest risks to your financial plan? And if so how can we reduce that risk?
How to Overcome Emotions and Control Behavioral Risk in Investing
With the recent resurgence of volatility across global financial markets we have seen investor emotions come to the forefront with alarming strength. In the media it is apparent that people are fearful and angry about the state of the current global economy. The current volatility across global market indices confirms the impact of these emotions and perceptions on investing. So how is it that the majority of my financial planning clients have managed to avoid getting caught up in the emotionally driven decisions of the masses fueled by the media? How have they been able to retain objectivity and maintain their logical and well reasoned financial decisions while others simply react? Throughout my recent conversations with clients it has become apparent that the answer lies in the existence and quality of a process within an individual’s financial lifetime. We all engage within many different relationships throughout our financial lifetimes. In fact many of us have multiple individuals advising us or helping us organize our financial affairs. It may be a stock broker who helps us purchase a certain security or fund, an insurance agent who helps us assess the risks within our lives and put in place the proper solutions to account for those risks, or it may be an accountant who advises us on the most efficient way to manage our cash flow. Regardless of the relationship, it is the process and quality of engagement in that process that allows an individual to remain objective and focused on the long term. Think about the many different relationships you have had throughout your financial lifetime and the most beneficial ones most likely involved strong engagement on the part of both individuals in a high quality process. The best way to protect ourselves from behavioural risk is to have a defined process or plan from the very outset of our financial lives. One would never imagine opening a business without having a proper business plan in place that describes who you are, your mission statement, a market analysis and projected cash flows. How is an individual any different? We need to engage in a process that is continuous throughout our entire lives. In my personal practice I have always believed in outlining and adhering to a process with all of my clients. Whether it be with an individual just starting to invest or with a long time investor who is now looking to turn their capital into an income stream. Each firm has their own take on the 6 steps of financial planning, however they all are designed to help alleviate behavioural risk. At Bumstead Financial we refer to our planning process as the 6-D approach to financial planning.
DEFINE
Prior to entering into any relationship it is important to outline the level of engagement that you and your planner will have. This is a great opportunity for you to see if your potential advisor shares some of your same beliefs and values. By clearly defining the rules of engagement at the outset of your engagement this avoids any confusion and reduces miscommunication throughout the lifetime of the relationship.
DISCOVER
Once you have defined the relationship and decide to move forward with your advisor, it is time to gather important data and beliefs about your personal and financial expectations. This is where your advisor needs to be asking the proper questions to help discern what is important to you and what kinds of strategies will benefit you most moving forward.
DECIDE
After the discovery session we should have a realistic snapshot of the current financial reality. From this snapshot the advisor needs to bridge expectations and reality by outlining the areas of concern or interest that apply to your specific situation.
DEVELOP
Potential opportunities and risks have been identified. Your advisor now introduces and educates you on possible solutions to these concerns or needs. Through education and understanding you become engaged and are better able to make sound financial decisions and employ the financial tools that make the most sense for you.
DO
Once we have identified and agreed upon the best course of action moving forward, then it is the time to put your game plan into effect. Through client comprehension the implementation of the financial action plan is done much smoother and with greater confidence.
DISCIPLINE
Your plan will change over time as your needs and goals shift. Your relationship and plan have to be continually updated to reflect those changes. For us this tends to be the most important part of the 6 step process. The only constant in life is change. What’s important to us changes throughout our lives, however the process we engage in does not. A good planner is adept at anticipating and knowing how their client’s priorities evolve over time and is able to help those clients prepare for it. If these personal and financial changes aren’t taken into account then even the most finely crafted plan can become obsolete or outdated.
Adherence to the plan and the process allows us to view our decisions from an objective standpoint. It reminds us of the motivations behind each action step we have implemented and removes our reactive emotions from the equation. It provides us with a road map for our lives and allows us to refer back to it in case of miscommunication on the part of either party. This engagement certainly requires work from both sides to be honest and open with each other at the outset as well as throughout the life of your engagement. I have found that this additional effort we demand from our clients up front avoids the frustration or lack of communication that often leads to a relationship break down with your advisor.
Have emotions affected your investment decisions? How have you managed to deal with the emotional aspect of investing? Let us know your experiences (good or bad) in the comments below.
Here are some keys to success for building a long lasting and mutually beneficial client-planner relationship.
Create the right type of environment
Individuals that are open to embracing the financial planning process tend to have the greatest success and commit to the process throughout their lives. It is very easy to to focus on the day-to-day management of our lives and forget about the long term direction of our lives.
Set measurable goals
We must be realistic in outlining our goals for ourselves and our families. These goals must be reviewed and progress must be marked against measurable and time weighted goals. If results are different than expectations then we must readjust for this, hence the importance of periodic review.
Start Now
Don’t assume financial planning is for when you get older. Start with what you have got and don’t dismiss planning as a process for only the wealthy.
Take Charge
The most involved clients tend to get the greatest results. There is nothing I enjoy more then working with an engaged client. They tend to have a greater understanding of the risks involved in their plan and are much better able to control the behavioural risk that is inherent when the unexpected occurs.
Don’t confuse financial planning with investing
It is about the big picture and impacts not just your finances but almost every single facet of your personal and professional life.
Don’t wait until a crisis to begin planning and engaging in the process. If you commit to the process and update your plan regularly then the crisis may not seem as such. It is then an expected event that we have anticipated and emotionally prepared ourselves for. Believe you me, the people that embrace the process sleep much better at night.
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