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Advisors can’t predict the next time we will face bubble trouble in the market. But we can prepare ourselves and our clients to counteract the human tendencies that go into making a bubble, and get in position to ride out the next—inevitable—collapse as comfortably as possible.
We’ve all heard a lot about bubbles lately. First there was the TMT Bubble from 2000 to 2002, and this past year, the global credit collapse—two bubbles of historic importance less than 10 years apart.
And even as the current crisis appears to be subsiding, there is likely another bubble brewing to take its place. It is the duty of advisors to prepare their clients for the next time the bubble bursts—because, inevitably, it will. Here are four tips from behavioral economics that will help you keep your clients’ bubble tendencies—and your own— in check.
The first three explain common bubble biases—the innate human tendencies that contribute to investors’ bubble behavior. And the fourth tip will tell you how to ride out the next bubble and its bursting.
1. Beware representative bias
Representative bias basically means that human beings are not very good at analyzing statistics, which can lead to critical misinterpretations of information. Picture yourself sitting down with a new client to evaluate a money manager’s performance.
You tell the client you have placed some money with a manager who has been in the business 20 years; his portfolio has outperformed the market 60% of the time. And then you have also found a new, interesting, different, perhaps younger manager who’s only been managing money for five years. But look, four out of five years, he’s had a great track record!
Most clients will jump on the newer guy: "Wow, this manager must be better with that streak of out-performance!" They pick the one that seems to have more success, ignoring the fact that he’s had less opportunity to fail!
So one way of helping clients prepare for future bubbles is to help them understand the data better—to correct that representative bias.
Depression-era financier Bernard Baruch once spoke about how as markets are declining, people absolutely feel everything is going to go to zero. And so clients are hesitant to try the market again in the aftermath of these uncertain times, and they often insist on going to cash. It’s sort of endemic in people’s psychology. So how do you convince clients that this time they will not lose everything? In essence, how do you win back their trust? I think it’s really a matter of having people look at long-term data and trying to interpret it for them.
One of the most interesting pieces of data that I have been using is 10-year rolling returns and looking at the cycles that are inevitable in the long term. Taking that long-term perspective—stepping back from what happened last quarter, last day, last six months—really does help people say, "It’s happened before; markets have recovered and prospered subsequently." It’s about giving clients that historical perspective. For some, it’s about showing them a chart. For other clients, it’s telling them stories or anecdotes about people who, like them, wisely and successfully stuck to a portfolio strategy.
It’s important to recognize that we work in a universe in which data and statistics are quite widely used, yet most individuals struggle with interpreting data. Even the best people in the financial business who use data on a regular basis make systematic errors with it. So it’s important to recognize that this struggle of interpreting data is really an important challenge. Find ways to give your clients the proper tools they need to make the smart decisions.
2. Counteract overconfidence
Investor overconfidence is another type of bias to counteract, and it comes in many guises. Here are the top three:
 Cockeyed optimism. First off, we know that as people look into the future, over time their predictions and forecasts start to become more and more optimistic. During a long absence of problems, investors grow comfortable and play down past unpleasant experiences. There’s a general drift to what one noted economist called the "too-rosy forecast of the future."
You’ve probably experienced this with clients. You can educate a client about stock market losses—that historically, markets go through periods of losing 50% of their value. But as the bull market years go by, people begin to lose that knowledge. Investors become too optimistic. They’re thinking, "Gee, this year the market might only lose 10%. And not only that, it could gain 20%!"
And even in leaner times, investors fall victim to the "rosier forecast syndrome." If there’s a strong bear market, clients find themselves thinking, "Well, maybe this year it might earn nothing…but it could earn 30%!" There is a tendency for our forecasts of our financial future to become rosier and rosier, until of course, a bad dose of reality hits.
I am the greatest. Another aspect of overconfidence is that we tend to overestimate our talents, particularly in our own fields. Managers provide the classic example. I actually just looked again at a study from BusinessWeek a few years ago in which 90% of middle managers said they’re above average and 97% of senior executives said they were the shining stars of the company.
How does overconfidence affect business? Well, for example, we know that CEOs typically overpay for mergers. Most mergers are value-destroying for shareholders. That’s because the acquiring company overpays, since the CEO is overconfident about his decision and the anticipated savings and synergies that will come out of the deal.
But let’s not pick on managers; overconfidence can affect anyone, from psychologists to investment bankers to entrepreneurs. (Although it has to be noted that men do tend to exhibit overconfidence more than women!)
There isn’t much of a correlation between overconfidence and other factors such as age or income. It’s simply that we tend to be overconfident in our own professions. Perhaps that isn’t very encouraging for all of us who work in the financial field. I just said there are these biases you need to overcome, and now I’m telling you that you’re most susceptible to overconfidence in your own professional work! But the key is in recognizing this correlation and consciously fighting it.
I am the master of the universe. Another common foible is to overestimate the level of control we have over events—and this is very relevant for advisors. Many clients perceive themselves as having direct personal control over their portfolios. There was an interesting study done at the University of Chicago, where they took a group of high-net-worth male investors and asked them how much control they had over their portfolios (either working with their advisors or self-directed). Most of them reported a strong sense of control. However, the people who analyzed the numbers found that 90% of their portfolio returns came from the stock market because they were well diversified.
Obviously, fighting overconfidence is easier said than done. But it’s just a matter of recognizing it and coaching yourselves and your clients on that aspect of decision making.
Now how can you apply this in the process of talking to clients and diagnosing how they’re going to react to the marketplace? It’s about looking for the overconfidence on one extreme and then the aversion to losses in the other.
A lot of clients over the past several years have become less accustomed to thinking about risk. They thought, "Hey, I lost money in 2000. But in 2002, markets recovered and that won’t happen again. So now I can be a bit more aggressive or be more complacent about what I should expect from markets." Again, we see the tendency toward a rosier forecast.
And then there’s a flipside of this: some clients are unduly sensitive to losses. It’s up to the advisor to detect that and make sure they’re in a more conservative portfolio. The idea is always to set portfolio risk based on the client’s ability to deal with the collapse, not the average rate of return.
I think there is this tendency for some advisors to feel they have a best strategy for most clients and their goal is to sell them into that strategy. But particularly with clients who are very risk-averse, the better strategy could be to give them a very low-risk portfolio. Better to match their portfolio to their risk tolerance than deal with the fallout of a portfolio that’s too risky for them.
3. Break away from group polarization
Bubble biases aren’t limited to individuals. Groups can be even more prone to such behavior. Group polarization is the idea that people tend to take more risks in a group than when working alone. This can happen in a whole financial system and in a whole market. Through modern telecommunications, through the Internet, through day-to-day communications and social interactions, people as a group become more risk-seeking than each individual would be alone.
So in preparing for bubbles, there’s the element of resisting the herd—recognizing that when we’re in markets and when we’re in groups, we have to resist the urge to follow the crowd if we want to be more effective investors.
But if we know human beings have this tendency toward the herd mentality, how should we handle ourselves in the marketplace? When should we be on our guard against group polarization, and when is it OK to go along with the in-crowd? This is the classic question about how tactical you can be about bubbles in the marketplace. And the answer is there’s not, in my view, much to be done in terms of tactical timing. Look at it this way: if it were 1996 and you were listening to Alan Greenspan and agreeing that it was a time of rational exuberance, you did have to wait four years before his forecast came true!
To clarify further, we just went through declining stock prices at 50% due to a totally different phenomenon, the tech bubble crash. But this time, because it’s occurring again, and not quite in the way people had expected it from the past bubble, it seems unusual. But all that says is you really can’t forecast these things and attempt to time them. You might get one right, but that will only sustain your overconfidence as you attempt to do it again! It’s a continual process of watching out for these biases.
If we can’t entirely predict when bubbles will occur, we can still be prepared when they do. Again, I think the real issue is to set portfolios based on your ability to ride out large collapses of bubbles. That way your clients can at least feel secure when the worst-case scenario does occur.
4. Learn from the past
Now that we’ve covered the three bubble biases, there is one more tip on how to ride out the next bubble storm.
When you talk about things like group polarization to financial people, they often interpret it as a modern social, psychological phenomenon. It all seems very new and intimidating. But the social and group aspects of risk are nothing new. Just look at another infamous time in our nation’s financial history—the 1929 stock market crash.
After the 1929 crash, financier Bernard Baruch wrote a little essay and drew an analogy between the market and insects flying in your garden. I think this really conveys the idea of how we integrate as a social unit and as a market:
Have you ever seen in some wood on a sunny, quiet day a cloud of flying midges—thousands of them—hovering apparently motionless in a sunbeam? …Yes?… Well, did you ever see that whole flight—each mite apparently preserving his distance from the others—suddenly move, say, three feet to one side or the other? Well, what made them do that? A breeze? I said a quiet day. But try to recall—did you ever see them move directly back again in the same unison? Well, what made them do that?
So Baruch, after the 1929 crash, sees not just the individual decisions being made by investors, but the whole social organism of the marketplace. He sees all of us as a group, if you will, shifting around to riskier and riskier positions, flying through the air and really not noticing it because we’re all preserving the distance between each of us—just like the midges flying in your summer garden.
My final recommendation is to share these insights, both from the past and present, with the next generation and to continue to communicate them to younger clients and younger advisors who are coming along in the field. Again, as with overconfidence, there is a tendency to forget the lessons of the past. But they are essential to our financial survival.
One intriguing element of this research is a famous investment game that some of the behavioral economists use where people engage in a bidding process with large market rises and crashes (so prices are soaring and crashing frequently). After about the 10th or 12th round, suddenly the bulls and the bears disappear and prices settle down and don’t fluctuate so widely.
So it does seem in some ways that a lot of the fluctuations we see in stock prices may be somehow related to experience. And that these sort of wild, over-excessive views of the future, these excessively optimistic, too rosy forecasts come from lack of experience. So the final word would be really sharing these insights with younger individuals in the attempt to at least help manage the next punch bowl, the next bubble.
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