The Origin of My Observations

Sometime in the middle of 1986 a senior partner in my law firm approached me about working (on a temporary basis) at one of our biggest clients - then one of the largest and most respected NYSE brokerage firms. I was asked to serve as counsel to the CEO of a division of that firm. I politely said no, stating that I was happy moving up in the ranks of securities attorneys in my firm. Not long after that I was asked again and was informed that although it was a request, because of pressure from the client, it was not a request I should decline. So on September 1, 1986 I left the safe confines of my law firm and began what would become a long and fascinating career as an attorney embedded "in the field" in a full service wire house.

My division was on the "retail" side of the equation and that meant that I would be involved in dissecting what happened between retail brokers and retail clients. My nearest in-house attorney/colleague was two thousand miles away. I was, for all intents and purposes on my own, surrounded by thousands of folks on the business side.  People of all stripes, executives, managers, brokers, operations personnel, sales coordinators,  margin clerks-you name them. This was a world that I thought I knew but did not - not by a long shot. I would, however, learn a great deal because I was totally immersed in the retail brokerage environment.

 In part my job turned out to be that of a radio call in talk show host.  In that role I functioned more as an on air psychologist than I did as a lawyer.  We kept track of the number of calls the first two years and I had an average of 47 calls per work day. These calls often involved brokers, sales assistants, managers, and most importantly clients. I never returned to my law firm, for some reason it just never seemed an opportune time to do so. Eventually my employer was acquired by another financial services firm which in turn was acquired by another. This pattern continued until I ended up at one of the largest financial conglomerates in the world.

As the years passed I became fascinated with the question of "why." Why did the people involved (especially clients) act the way they did, say the things they said and decide the way they decided?  My curiosity only increased and in 1996 I read a law review article ("Selling Hope, Selling Risk: Some Lessons for Law from Behavioral Economics about Stockbrokers and Sophisticated Customers," 84 Cal. L. Rev. 62 (1996)) by Professor Donald C. Langevoort. This article had some interesting (I would say fascinating but the article was just a bit dry) comments on the psychology of investors. I read and re-read that article and boiled it down to what I thought were the essential principles it discussed, wrote them down on a tablet and kept those comments in front of me and  in mind during the succeeding years.  During my phone calls and meetings I observed whether those comments turned out to have some validity.  I found many of them accurately described what I observed.   Here are a few of my "Observations:"

Hindsight Bias

This is the natural tendency of an individual (most importantly a client) to overweight the probability that an event (such as a loss on an investment) would occur after being told that the event had occurred. 

Net Worth

An individual's view of the value of their assets is not what they currently have but rather a mental picture of what they expect to have at some specific time in the future.

Loss Framing

When an individual ultimately perceives that they will not have the value of assets specified in their mental picture of their net worth they "frame" a "loss" and consider it as a realized loss rather than a potential failure to reach a goal.

  

Increase in Risk Assumption

An individual who frames such a loss often reacts by desiring to increase the level of risk in their investment portfolio to make up for the perceived loss.

Social Comparisons Increase Risk Assumption

Individuals engage in social comparisons in investing and increase the level of risk in their investment portfolio when they perceive that they are falling behind their peers in their investment performance.

Overconfidence

People exhibit overconfidence in their ability to predict future events leading to an underestimation of risk.

Self Esteem 

Self-esteem is a motivating factor in the investment arena.  Successes are attributed to the exercise of skill.  Failures are attributed to external causes.

Risk assessment 

Risk taken by an investor often takes the form of failing to perceive and appreciate the risk as opposed to its deliberate assumption.

Stress 

Mental recognition of risk causes stress.   Investors tend to avoid the perception of risk, and thereby avoid stress.

Trust

The transfer of trust to a financial advisor greatly reduces stress for investors.  To avoid stress investors often transfer significant, if not absolute, trust to the financial advisor.

Admitting Mistakes 

Once investors make a decision, changing direction implies that they have made a mistake.  Investors tend to filter out facts suggesting that they made a mistake, thereby avoiding the perception of risk and its consequent stress.

The selection of a financial advisor presents investors with the opportunity to assume the greatest amount of risk.  Investors often take advantage of the opportunity.

Once committed to the relationship with the financial advisor, investors will resist any notion that they are being exploited.  Entertaining suspicion would force the investor to reconsider their initial commitment, admit that perhaps they made a mistake, perceive risk and incur stress.

Contrary feedback must be immediate and unambiguous to overcome an investor’s resistance to a contemporaneous admission that they made a mistake.

Eventually, however, if loss-framing occurs the investor’s prior resistance will be overcome.  At that point the investor will conclude that their trust has been breached, and begin to complain, often criticizing (long) past investments and their dealings with the financial advisor (even while the FA was at prior firms).      

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By no means is that a complete list of or discussion about what I observed. I will have more to say in future Observations.