Find A Financial Life Planner
Risky Business
By Roger Wellington, Executive Director
Let’s compare two different people: one wins $100 million in the lottery, the other has an accident and loses the use of his legs. Which one will be happier with their life six months after these events? Easy, right? The lottery winner! However, actual research with lottery winners and new parapalegics reveals an astonishing result. Members of both groups are equally happy with their lives six months later. Honest! What’s going on here?
In his brilliant and funny best seller Stumbling on Happiness, Harvard psychologist Daniel Gilbert tells us why. He proposes that the unique competence of the human brain is its ability to envision the future: We hurry to an appointment because we imagine the embarrassment or inconvenience if we’re late. We stop at a red light because we can imagine the accident or traffic ticket that might otherwise result. We save for retirement because we have imagined what life will be like 20 years from now.
However, he demonstrates in great detail that we repeatedly overestimate the impact that future events will have on our actual experience. His research shows that all of us dramatically and continually mis-predict how happy or unhappy we will be in reaction to life events. Humans, he says, have the ability to “synthesize happiness” in a way almost entirely independent of outer events. We have in essence a psychological immune system that modulates our experience, enabling us to deal successfully with profound loss and adversity. (If you don’t have time for the book, don’t miss his terrific 20 minute lecture on the topic: http://tinyurl.com/mmqopj ).
What does this have to do with Life Planning? Well, here at the Institute we’ve been thinking recently about the nature of risk tolerance and the way financial advisors seek to measure it as a guide to portfolio construction. Many advisors use some form of questionnaire to document a client’s risk profile so they can guide them to conservative or aggressive investment choices as appropriate. Seems straightforward, right? However, such risk assessment exercises assume that we are capable of correctly imagining a future and ranking how happy we will be under different scenarios. At markets drop, we might inquire, “What would make you feel worse: losing more of your capital or missing out on an upturn?” We are asking clients to predict their emotions. The research shows that people without exception are perfectly lousy at doing this.
Financial markets over the last year have tested everyone’s ideas of risk tolerance. How many investors got skittish and sold despite their earlier declarations about being long-term investors? The thing that typical risk tolerance tools miss is that during violent market swings, humans experience even more violent swings of emotion. Investors tend to overpredict their expected happiness when markets soar and underpredict their panic when markets sink. The herd rushes in during upswings and stampedes out during downswings.
Because financial Life Planners are better equipped to speak to clients’ emotional experience of money, they are capable of moderating these natural tendencies. Life Planning concentrates first and foremost on a person’s life, not the absolute value of their holdings. Hopefully, that leads to discussions with clients more focused on how to adjust a life plan given changing asset values rather than reviews of relative performance. And there are other ways to acknowledge the emotionality of market swings. One Life Planner I know has organized group sessions for his clients during which everyone gets to speak about their fears and frustrations. As they listen to each other, participants’ anxiety and isolation subside as they realize they are part of a community of people all experiencing similar difficulty.
In whatever way you deal with client expectations and risk tolerance, it’s easy to see that understanding the emotional nature of a client’s essential life goals will make you much better prepared to respond to them regardless of the market cycle.