Portfolio

K E Y P O I N TS Managing stress helps advisers think clearly and make more rational decisions. Advisers should stay focused on the present rather than worry about past events that cannot be altered. Enhancing your perception of control is the rst step when trying to manage stress. Focusing on the elements of your life that you can control can help reduce stress.

PERFORMANCE

Serenity Now
The ability to manage stress can affect the quality of decisions
BY NANCY OPIELA

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P RO F E S S I O N A L P R AC T I C E

othing is more difficult, and therefore more precious, than to be able to decide, Napoleon Bonaparte once said. For portfolio managers, todays volatile market further complicates decision making. While stress hormones such as adrenaline and cortisol can help managers handle the unexpected, they also can hinder the ability to think clearly by causing impaired short-term focus, increased pessimism, impaired concentration, and decreased patience. Accordingly, soaring stress levels often predispose investors to make information-processing mistakes and trade impulsively. Our brains primitive fight-orflight instincts worked well when we needed protection from a marauding wild animal but are less helpful when managing modern sources of stress like market volatility or unhappy investors, explains Michael Ervolini, founder and CEO of Boston, Massachusetts-based Cabot Research, a firm that evaluates portfolio managers decision-making patterns to identify places where behavioral tendencies harm performance. This instinctive override of conscious decision-making limits us to using the part of the brain that doesnt want to think and prefers action. With the pressure-cooker market likely to persist, how can you ensure your portfolio moves reflect rational analyses rather than gut reactions? Effectively managing stress depends first and foremost on increasing your sense of self-efficacy to enhance your perception of control, notes Ervolini: The more capable we feel in any given situation, the less distress. In a recent interview about the current financial

crisis, Daniel Kahneman, winner of the Noble Prize in economics, related a story illustrating the value of believing you are in control: A group of Swiss soldiers gets lost in the Alps. After several days, with supplies dwindling, one of the men suddenly realizes he has a map, and with map in hand, the soldiers manage to reach a town. When they return to their base, the commanding officer asks how they made their way back. The soldier replies, I suddenly found a map. The officer looks at the map and says, You found a map, but its not a map of the Alps. Its a map of the Pyrenees. According to Kahneman, the map, even though it was a worthless document, provided a sense of security that bolstered the soldiers confidence and determination, helping them reach their goal. Portfolio managers can create real security by exploring self-awareness, discipline, and processtools that strengthen feelings of self-efficacy and control. The more you understand and believe in what you do at each decision point, the better you can manage stressors, says Ervolini. As you learn to harness stress, the more your portfolio decisions will reflect your strategy and analytic thinking rather than those unexamined rules-of-thumb hiding in your unconscious. Because stress often surfaces in areas where judgment plays a greater role, Ervolinis Cabot Research targets the sell discipline. Self-awareness depends on spending the time to ensure your sell process is comparable in strength and durability to your buy discipline, he says. Theres confidence to be gained in knowing you have a strategy that has worked and a process in place to measure and ensure that strategy is highly repeatable.

The quest for self-awareness can take many forms. Some portfolio managers with whom Ervolini works record the when and why of every sell. Every few months, Cabot Research evaluates the portfolios to determine whether managers adhered to their articulated sell discipline and whether these moves played out profitably. The severity of the current recession has moved managers beyond using simple breathing and relaxation techniques to manage acute stress, and they now need a more formal approach to deal with chronic stress, according to Richard Peterson, managing partner of MarketPsych, a Santa Monica, Californiabased firm that trains financial advisers, portfolio managers, and analysts in emotion management and behavioral finance. The release of anxiety is to assert control, he explains. The problem with most anxiety is we are uncertain about what to try to control and what we can control and, of course, nobody can control the price action of the market. Managers can gain a sense of empowerment from focusing on things they can control, such as information. Often, when managers review their multitude of information sources, they find they really only use two or three pieces of information to make every major decision, says Peterson. Everything else creates distracting noise, and it should be eliminated. Another key to successful decision making in the midst of market stress is to think positively and plan ahead.

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When the inevitable black swan surfaces, we respond, I never considered this. Now what do I do? says Peterson. In the heat of the moment, when you are already invested and losing money, you cannot think clearly. So, we ask managers to write down a plan in advance for what to do when facing the truly unexpected. Portfolio decisions are governed by investment objectives outlined in a funds prospectus. Accordingly, Peterson advises, Accept prices where they are right now. Dont expect or, even worse, hope that prices will rebound. The money is gone, and worrying, regretting, or feeling guilty doesnt get it back. Portfolio managers hired during boom periods can have particular difficulty handling downturns. When managers take over portfolios, I suggest they write down in advance the idea that in a downturn they might have a few years of their strategy not working, of not getting a bonus, says Peterson. We all understand the market is cyclical, but recording that fact can help avoid the stress of thinking What have I done? Im an idiot during a downturn. To beat stress and move forward, Peterson encourages his clients to let go of extraneous worries and concerns and focus on actions that can be taken right now. Moreover, he adds, With all assets declining in the recession, its become clear that the way we were thinking, the way most people had invested, was wrong. This is a credit crunch. So what can you control? You can control how you go back in history and research credit crunches and rethink what to do with your portfolio.
Lessons for the Frontlines

For financial advisors who are dealing with declining assets and revenues, along with pressure from clients demanding short-term performance results, taking action may provide enough stress reduction to prevent harmful emotional reactions. Its a psychological game, says Rick Ferri, CFA, founder and CEO of Portfolio Solutions in Troy, Michigan. Today, the old clichs like stay the course dont work anymore. Our

clients want us to do something. Recently, many have urged us to stop the rebalancing necessary to get their portfolios back to their original allocations, which in most cases means selling bonds and buying equities. Rather than stop rebalancing, however, Ferri offers to rebalance to a different allocation, one that dials down risk by reducing equity exposure by 10 or even 20 percent. Sometimes that suggestion alone, my offer to do something, settles a clients nerves, and we decide to stick to our original plan, he says. My job as an advisor is to keep clients invested and moving toward their goals, but like a good coach, I realize there are times we need to make a slight change to our game plan. Ferri also uses another behavioral technique that could be instructive to portfolio managers. Included in each clients financial plan are instructions for what should happen in the event that the portfolio declines by a particular percentage. For many clients, says Ferri, their reaction to the recession has been a healthy Good thing we prepared for this, and that keeps them from doing something crazy, like cashing out their accounts. Additionally, to calm impatient investors, financial advisors like Jeff Spitzmiller, CFA, chief investment officer at Iron Point Capital Management in Cincinnati, Ohio, have beefed up their communications programs to control clients anxiety, help advisors focus on their role as a fiduciary, and resist pressure from clients who want to see instant results for their fee. Institutional managers could benefit from a similar approach. Our recent client communications included weekly commentaries, conference calls, individual client meetings, and client seminars, explains Spitzmiller. We addressed the difficult market times, the impact on portfolios, and the tactical moves we made to address the market risks and opportunities. This extra hand-holding provided a calming affect for clients and has helped all of us to stay invested in the long-term strategy.

A Look Ahead

As markets continue to fluctuate, managing negative stress not only can enhance the ability to think clearly, which may have a positive impact on portfolio returns, but also can help managers ensure that portfolios are well positioned for the eventual market rebound. In these tough times, managers need to use every innovation available, says Ervolini. Applying the tenets of behavioral finance to build self-awareness is the next innovation. Increasing self-awareness also can help firms manage clients concerns about risk control, which has become increasingly important in the postMadoff investment environment, notes Liz Hecht, principal and director of research at Alpha Partners, a research and marketing communications firm based in Park City, Utah, that works with investment managers. Today, theres plenty of room to increase transparency, and that includes drawing the curtains on the investment process and the stress-management techniques of portfolio managers, she says. As a first step in this uncertain market, weve been telling our clients that a developed, articulated sell discipline is a key element to risk control and a potential competitive advantage, given the scarcity of well-defined sell disciplines. Indeed, Hecht and Ervolini look ahead to a time when, in addition to an explanation of buy and sell disciplines, a discussion of how managers build and retain self-awareness will be included in investment firms pitch books alongside performance numbers. Nancy Opiela is a freelance nancial journalist based in Medeld, Massachusetts.
RECOMMENDED RESOURCES
Animal Foraging and Investors Portfolios Summarized in CFA Digest (Aug 2009) (www.cfapubs.org) Managing Assets in Turbulent Markets Conference Proceedings Quarterly (Mar 2009) (www.cfapubs.org) Applied Behavioral Finance Conference Proceedings Quarterly (Mar 2009) (www.cfapubs.org)

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