Managing Investments; Understanding Investors
By RBC Dain Rauscher and Ray Arata

A financial consultant's primary mission is to identify a client's life goals, translate them into a set of financial objectives and develop an investment strategy to achieve those objectives.

Modern portfolio theory offers a method of constructing portfolios that are diversified enough to produce the highest level of return for a given level of risk, and with time allow the client to arrive at his or her predetermined objectives – at least theoretically. However, investors and advisors often react, even immediately, to market movements. The result: actual investment decisions that often deviate from the plan. So what happened?

One theory is that traditional approaches to portfolio construction do not adequately recognize the many behavioral challenges associated with investing. It is widely agreed that aversion to loss prompts a significant portion of investor behavior. But behavioral research further suggests that investors feel the pain of loss 2 1/2 times more strongly than the pleasure associated with a gain. Although a recommended portfolio may in actuality reduce investment risk, the client may not perceive it that way. In fact, even hedging strategies can cause investor anxiety.

Different investors also perceive progress towards a financial objective differently. Each investor has an individual frame of reference that influences how they interpret their plan's success and ultimately whether or not it is executed. For example, some are swayed by past experiences, spousal biases, success or failure of friends, and media exposure. The result is that a theoretically well-designed portfolio, against the backdrop of an investor's personal experiences, may produce enough conflict to ultimately alter the investor's ability to stay the course.

The definition and tolerance of risk is another area of challenge. Some view volatility as risk, others view it as an opportunity. Tolerance for risk changes as markets fluctuate. Investors tend to be more aggressive in rising markets and more conservative in declining markets.

Since many investors often have "non-rational" preferences, a financial consultant needs to be both an investor manager and an investment manager. Trying to construct appropriate portfolios, which take into consideration investor preferences and psychological make up is difficult. But open communication can help an investor reach his or her financial goals.

The information included in this article is not intended to be used as the primary basis for making investment decisions nor should it be construed as a recommendation to buy or sell any specific security. Consult your investment professional for additional information and guidance.