Behavioral Science and Volatility
TEXT ON SCREEN: PIMCO
TEXT ON SCREEN: PIMCO EDUCATION – TITLE –Behavior Science and Volatility with John Nersesian (9 minutes)
TEXT ON SCREEN: John Nersesian, Head of Advisor Education
TEXT ON SCREEN: PIMCO provides services only to qualified institutions and investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. The information presented in this video is intended for educational use with investment professionals only. Some references may be region specific, dated or not applicable for all viewers. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation.
Nersesian: Hi, I’m John Nersesian, head of Advisor Education at PIMCO. Welcome to our conversation around behavioral guidance during market volatility. The past few months have exposed our clients to significant volatility, both emotionally and in their financial portfolios as well. We’re going to examine some of the very best practices that top financial advisors are utilizing to keep their clients on track and to ensure the long-term returns that they seek.
TEXT ON SCREEN: TITLE – Market landscape; SUBTITLE – Cumulative price return of each U.S. bull and bear market (%)
IMAGE ON SCREEN: A line graph shows the performance of average bull and bear markets, from 1950 to early 2021. A logarithmic scale on the vertical axis shows bull market returns, from zero to 600, and zero to negative 300 for bear markets. Bars showing cumulative price returns for 11 bull markets over the time period dwarf the same metric for nine bear markets. The chart notes that the average bull market had a total return of 279% and lasted 72 months, while the average bear market had a total return of negative 33%, and lasted 12 months. The largest bull market, from about 1987 to 2000, had cumulative return in excess of 500%, while bear markets never fall minus 50%.
Let’s take a look at bull market and bear market experiences. It’s my belief that more money is lost in anticipation of bear markets than in the actual bear markets themselves. Let’s examine the S&P 500 returns going all the way back to 1950. And while these periods of market draw-down can be upsetting, it is the returns available during the longer duration bull market experiences that enable our clients to achieve the financial results they seek in order to realize their long-term financial goals.
Geopolitical shocks like the one we’re enduring currently can have a significant emotional impact on our clients and their approach to investing.
TEXT ON SCREEN: TITLE – Market reactions to geopolitical shocks; SUBTITLE – S&P 500 Index
IMAGE ON SCREEN: A table shows a list of eight geopolitical shocks, the resulting equity drawdowns and subsequence performance of the S&P 500 index. The list includes, in reverse chronological order: the bombing of Syria, Brexit vote, Russian invasion of Crimea in Ukraine, Arab Spring, Iraq war, 9/11 attacks, Gulf War, and Soviet invasion of Afghanistan. Drawdowns lasted for these events between zero days for the Arab Spring to 11 days for the Iraq War. Almost all events show positive gains 12 months forward, ranging from 0.10% for the Arab Spring and 38.44% after the Gulf War, with 9/11 as the exception, which was followed by a 12-month negative return of 15.5%. The rebound of equities is similar for one month after the starting date, with returns ranging between 1.86% and 18.07%, with only 9/11 showing a negative market return of 0.93%. Most events show positive market returns three months forward, with only the Soviet invasion of Afghanistan as the exception, where returns were negative 4.5%. The chart also highlights the Russian invasion of Ukraine in 2014, with the drawdown lasting one day, and forward S&P 500 returns of 1.93% after one month, 3.61% after three months, and 17.06% after 12 months.
Take a look at some of the more recent events—the bombing of Syria, the Iraqi war, the 9-11 attacks. And while the draw-downs experienced during each of those particular events may have been significant, take a look at the forward returns 1 month, 3 months, and 12 months later where significant returns were available to investors who were able to endure those periods of short-term market decline.
TEXT ON SCREEN: TITLE – Market reactions to geopolitical shocks; SUBTITLE – Barclays U.S. Aggregate Index
IMAGE ON SCREEN: A table shows a list of eight geopolitical shocks, their resulting drawdowns and subsequence performance of the Barclays U.S. Aggregate Bond index. The list includes, in reverse chronological order: the bombing of Syria, Brexit vote, Russian invasion of Crimea in Ukraine, Arab Spring, Iraq war, 9/11 attacks, Gulf War, and Soviet invasion of Afghanistan. Performance of the index ranged from negative 0.54% for the Arab Spring drawdown, to zero after the 9/11 attacks and Soviet invasion of Afghanistan. The bond index recovers 12 months forward for all of the events, and by as much as 15.19% after the start of the Gulf War in 1991. The chart also highlights the Russian invasion of Ukraine’s Crimea region in 2014, with the bond index rebounding by 1.88% after three months and 5.07% after 12 months.
The same results can be found by looking at the fixed income market, as represented by the Ag. The bombing of Syria, the Iraqi war, and the 9-11 attacks once again all produced significant draw-down during the events. But a 1-month, 3-month, and 12-month forward-looking view provided significant opportunities for investors to earn the returns they seek.
Now, when we think about behavioral guidance, we think it’s an important role that the financial advisor plays in helping their clients control their emotions and the way in which they process information in order to draw logical and productive financial conclusions.
This concept of behavioral finance has a significant impact on investor returns, and many advisors refer to their alpha, their value in that client relationship, by providing guidance, particularly during periods of extreme market volatility.
TEXT ON SCREEN: TITLE – Introduction to behavioral finance; SUBTITLE – The cost of bad behaviors
IMAGE ON SCREEN: A bar chart compares the market return of the S&P 500 index with that of the average equity fund investor, from 2000 to 2020. Performance is shown as solid, vertically-oriented blue bars. The bar representing the S&P 500, on the left, is taller than the one depicting the average investor return on the right. The region above the investor return is shaded with diagonal lines up to the height of the S&P 500 performance on the left, representing the behavior gap and difference between the two metrics. The chart also notes that investment results are more dependent on investor behavior than on investment performance, and that investors are generally their own worst enemy.
Take a look at the DALBAR results that examine the market return from 2000 to 2020. And while the market provided ample opportunity for investors to earn decent returns, the average investor often underperforms. It’s not due to a lack of intelligence. It’s not due to a lack of effort. It’s the impact of emotions on financial decisions, which often lead investors astray.
TEXT ON SCREEN: TITLE – Common biases
IMAGE ON SCREEN: A visual graphic shows two columns to show common biases. On the left, the column is labeled “cognitive,” and includes concepts such as anchoring, confirmation, framing and mental accounting” The right-hand column, labeled “emotional,” includes the factors loss aversion, recency, overconfidence, and status quo.
Here are some of the common biases that cause these divergent results. We’ve identified both cognitive biases, those that are affected by the way in which we process information, and then emotional biases, those that are governed by the way that we feel and our reactions to market volatility.
One common bias that often has a significant impact on investor results is recency bias.
TEXT ON SCREEN: TITLE – Recency bias – trend chasing; SUBTITLE – Investor’s behavior and thoughts during a volatile market (2006–2010)
IMAGE ON SCREEN: A line graph shows the fluctuations of a $100,000 portfolio from 2006 to 2010. Working from a base of $100,000 in 2006, performance peaks at almost $120,000 in the first half of 2007, and bottoms around $90,000 in early 2008. The market recovers by 2010 to $111,694. Along the trajectory, the chart indicates various emotions of the investor. Those who panicked and sold near the bottom and bought back in after much of the recovery achieved a portfolio worth of just $93,320 by 2010. Had they left the money untouched, the portfolio would be worth $111,964. The chart also uses bars to show monthly inflows and outflows, with the latter being the greatest in early 2008. Three bulleted items are listed, showing how investors favor recent returns, follow trends, and chase performance.
You know it well. It’s the idea that investors feel more comfortable adding money to risk assets after periods of strong market returns, and they use decline in risk assets as an excuse or rationalization to reduce their exposure.
This tail wagging methodology is often what produces that significant gap between market returns and investor returns. We’ve identified a number of best practices that advisors can use to help keep their clients on track.
TEXT ON SCREEN: TITLE – Strategies to mitigate behavioral biases
IMAGE ON SCREEN: The chart lists seven strategies to mitigate behavioral biases: (1) identify behavioral risk, (2) create an investment policy statement, (3) enroll in automated investment programs, (4) diversify to reduce portfolio volatility, (5) consider asset bucketing, (6) encourage a long-term perspective, and (7) rebalance portfolios regularly.
Number one, to identify the appropriate behavioral risk for each of their clients individually. Second, to develop long term investment policy statements, guardrails if you will, to help make future financial decisions.
We encourage advisors to utilize automated investment programs, including dollar-cost averaging, to help reduce the temptation to time markets. We also encourage diversification, not just for additional return opportunities, but to smooth out market results, which can help to keep our clients emotionally on track.
Asset bucketing is the concept of immunizing various financial objectives to help our clients rest assured that their objectives will be satisfied. Of course, we encourage clients to take a long term perspective.
And then finally, the concept of rebalancing, which forces the investor to do what is financially productive but emotionally uncomfortable.
Let’s go further in this conversation about risk. It’s a four letter word that means different things to different clients.
TEXT ON SCREEN: TITLE – Identify behavioral risk; SUBTITLE – Defining risk effectively: Risk is abstract
IMAGE ON SCREEN: A graphic shows a box with various words related to the realm of behavioral risk, such as loss, tolerance, variance and unpredictable. The words are given difference emphasis through variance in size. Underneath, the text reads: “Risks are often expressed in the form of probabilities. But for many people, probabilities are less important than consequences and exposure.”
Some clients define risk as market volatility, others as a loss of capital. Others define risk as the probability or failure to achieve their unique financial goals. We think probabilities are less important than the consequences suffered from risk and the exposure that our clients have to them.
TEXT ON SCREEN: TITLE – Identify behavioral risk; SUBTITLE – Discovery questions
IMAGE ON SCREEN: The image contains a list of discovery questions. They include the following: How has the recent volatility affected you? Has it changed any of your personal goals? How do you define risk? How do you measure it? How do you try to manage it? If you received new funds today, how would you invest them? What would be more disturbing: holding securities that continue to decline in value, or selling securities that eventually rise?
Here are some questions that can help us further identify our clients’ individual feelings towards risk. How has recent market volatility affected you? Has it changed or altered any of your personal goals? How do you specifically define risk? How do you measure it? And how do you try, or what steps do you take, to try to manage it?
If you received new funds today, how would you allocate that capital given the recent market volatility that we’ve all experienced. What would be more upsetting to you, holding securities that continue to exhibit volatility or selling securities and missing out on the eventual rebound?
TEXT ON SCREEN: TITLE – Identify behavioral risk; SUBTITLE – Risk exposures
IMAGE ON SCREEN: The chart shows six icons, each representing the following risks: market, liquidity, inflation, interest rate, political and credit. Above the icons, the chart notes that from a client’s point of view, a risk is relevant if it involves an identifiable hazard, the client has exposure to the hazard, the consequences are too severe for the client to ignore, and the probability of negative consequences is high enough to make the combination relevant.
When it comes to behavioral risk, we think there are a number of critical steps in managing these risks appropriately for our clients, the first of which is to identify whether or not that risk exposes us to an identifiable hazard and then determining the consequences of that risk and the probabilities of occurrence.
We’ve identified a number of financial risks that your clients may be exposed to for further clarification. Finally, when it comes to communicating with our clients during periods of significant volatility, it’s critical that we allow our clients to embrace the appropriate guidance that we’re capable of delivering.
TEXT ON SCREEN: TITLE – Communicating effectively; SUBTITLE – Beyond “Stay the course”
IMAGE ON SCREEN: The image shows the divergence of what “Stay the course” is intended to mean, versus what clients hear. Under what “Stay the course” is intended to mean, shown on the left, bullets note the following: a client should stick with their solid long-term financial plan, not make any drastic portfolio changes that could have a long-term effect, note that timing the market is counterproductive, and that the client’s long-term plan and approach has validity. On the right, a bulleted items highlight what clients hear: my financial advisor is ignoring the pain I am enduring with this volatility, isn’t concerned about my situation, is unwilling to spend the time and energy necessary to make appropriate portfolio changes, and that the client should stick with their solid, long-term financial plan.
One of the phrases that we often hear is, stay the course, which is well intended. Stay the course, I suspect, is intended to suggest that clients should stick with their long term viable financial plans. They shouldn’t engage in market timing or make any drastic changes to their current investment portfolios.
Unfortunately, clients may misinterpret the advice. What they might be assuming is that the financial advisor doesn’t understand the emotional pain that I’m currently enduring. They’re not empathetic. My financial advisor isn't concerned about me or my current financial situation. Or maybe my financial advisor doesn’t have the time or the expertise to provide me with the guidance that I seek.
We think there’s a better approach. We think clients need to understand that we hear them and that we recognize the financial and emotional pain that they may be enduring during these periods of volatility.
We encourage you to continue to consult with your clients in a productive manner that considers their unique situation and their specific financial objectives.
We’ve done a lot of work on the concept of behavioral finance and have assembled a number of resources that may be helpful to you in your best practice endeavors. We encourage you to visit the PIMCO website or to contact your PIMCO account manager to learn more.
Text on screen: To learn more visit Advisor Education at pimco.com or speak with your Account Manager
Text on screen: PIMCO
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