In Volatile Markets, Remember This One Important Lesson from Psychology

Written by: Ken Haman

The AllianceBernstein Advisor Institute’s mission is to improve the commercial success of retail financial advisors by teaching them practical insights from the behavioral sciences. We often discuss Dr. Daniel Kahneman’s groundbreaking studies into the vulnerabilities that are built in to how humans make decisions. One of his most important findings was that people tend to feel much more pain when they experience a loss compared to the pleasure they feel when experiencing a gain. Kahneman calls this loss aversion.

Kahneman’s discovery has even been witnessed in non-human primates. In a 2006 study, two capuchin monkeys were placed in side-by-side cages so their reactions could be observed. One monkey was given two pieces of apples while the other was given nothing. Their reactions were predictable: the monkey with two pieces was delighted while his friend was outraged.

The experimenter then removed one piece of apple from the first monkey’s cage and gave it to the second monkey. The result revealed an important insight about the way monkeys think: the first was outraged that he had lost a piece of apple even though he still had the other piece! Instead of feeling great that he had one piece, he felt angry about his loss.1

Even Imaginary Losses Can Stimulate Strong Negative Feelings

This is an example of loss aversion: having an emotional reaction to a loss rather than making a rational conclusion. The strong feeling of outrage was not in the monkey’s control; loss aversion operates at a visceral level.

I’ve had my own experience with just how irrational loss aversion can be. One day, I was playing blackjack on my phone. Importantly, I was not on a gambling site; it was an app that allowed me to pretend I was betting. To understand loss aversion, it’s important to note that no money was involved.

I knew the statistics behind how blackjack works, so I played conservatively according to the rules. I could often play for a long time without losing everything. But on that day, I lost 12 hands in a row, won two rounds and then lost another eight rounds in a row. I shut off the app in a huff; it was weeks until I played again.

The monkey and blackjack stories are examples of emotionally intense but utterly irrational reactions. The monkey still had a piece of apple and I hadn’t lost a penny, but we were both deeply impacted by our sense of loss.

Clients Are Fundamentally Irrational

Loss aversion is something that every advisor needs to be familiar with. If she wants to successfully manage client relationships, she must anticipate how a client will react to a loss. Here are three important insights:

  • A loss always feels bad. When investment portfolios lose money, the loss will stimulate strong irrational feelings. Even just one part of the portfolio decreasing in value can stimulate loss aversion. Some clients can rationalize their feelings, while others tend to show their anger more overtly. Regardless of how a client copes, loss aversion stirs powerful feelings that are not rational. Remember that I was upset with my game even though I hadn’t lost any real money!
  • A loss will be even more painful if it is a surprise. The monkey wasn’t expecting to lose a piece of apple, and I had expected to trade winning and losing hands with my imaginary dealer. In both cases, we experienced an unexpected negative event that activated a primitive reaction. A surprise loss causes the brain to activate the fight-or-flight response. This survival instinct, hardwired into the brain, gets the body ready for action.
  • An unexpected loss shifts the emotional response from feeling concerned to feeling threatened.

The practical implications of this are clear: Would you rather work with a concerned client or a threatened one? When a client is concerned, he can be taught about market dynamics, how the portfolio has been designed and how to maintain a long-term perspective. Working through a short-term loss can be a great way to advance the advisor-client relationship.

But if a client is surprised by a loss, he will feel threatened, and it will be too late to use the event as a learning experience. When fully activated, the fight-or-flight instinct stimulates an intense desire to take some kind of impulsive, immediate action.

When markets become volatile, it is best to proactively talk about what is happening. Introducing the possibility of losses prepares the client ahead of time. This shifts the experience from an unexpected negative event to an expected one. Eliminating the surprise tends to dampen most clients’ fight-or-flight instinct. If prepared for a short-term loss, the client can face his pain, engage his rational mind, learn about the markets, understand your approach and then make a more rational decision about how to respond.

Related: The Myth of the Perfect Investment