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Research Paper

Advising the Behavioral : Keys to Helping Clients Stay Rational in Times of Market Turmoil By Gregg S. Fisher, CFA, CFP® President & Chief Officer, Gerstein Fisher

While markets are unpredictable, one thing that seems certain is that an ever-greater premium will be placed on advisors’ ability to manage the emotional/behavioral aspect of the client relationship. By educating their clients on an ongoing basis and helping them to maintain perspective and stay focused during times of market stress, we believe advisors can help their clients make better decisions – and ultimately experience better investment results.

In this paper, we explore how advisors can help their clients overcome emotion, navigate risk and stay rational – even when the global financial markets are anything but.

Introduction “The only thing we have to fear is fear itself.” This famous quote comes from US President Franklin Delano Roosevelt’s first inaugural address in 1933, when the country was in the throes of the Great Depression. Yet it seems just as relevant today: global financial markets remain fragile in the wake of the meltdown; economic growth is stagnant; unemployment is rampant, and equity market remains high. According to the National Bureau of Economic Research (NBER), the US recession that officially ended in June 2009 was the longest since the Great Depression. Coming out of it, many economists and market prognosticators are forecasting anemic growth at best, and at worst, a “double-dip” scenario in which the country bounces out of one recession directly into another one. In such environments, it’s easy for to become daunted, fearful, and risk-averse. But academic research in the field of behavioral bears out that FDR was right. Investors are often their own worst enemy by virtue of the fact that they are human beings susceptible to human emotions. When acted upon, those emotions are often responsible for poor decision making that ultimately leads to poor investment results. One of the greatest services a financial advisor can provide to his or her clients is helping to ensure that in times of market turbulence, reason, discipline, and objectivity triumph over emotions like fear, greed and regret. Part I of this paper will explore how investor emotions correlate to market cycles, and the outcomes that can result when those emotions go unchecked. It will equip financial advisors with a toolkit to help their clients avoid key emotional pitfalls, emphasizing the importance of investor education in this process. Part II will take a closer look at the current landscape for investment risk, including new ways of thinking about and discussing risk with investors, and ensuring that their risk-taking behaviors are appropriate given their near- and -term objectives and constraints.

I. Beyond Fear and Greed: Helping Investors Overcome Emotion If knowledge is power, perhaps the most important way an advisor can help his or her clients is to equip them with an understanding of (i) how their behavior can negatively impact their investment decision making and (ii) how to overcome these behaviors with concrete tactics. Thus, education is a key component of coaching clients on how to become more rational, and therefore more successful, investors. In this section, we will highlight key areas on which to focus in this regard. Remind Them Why They’re Here Within the past few years, 2008 stands out as an especially punishing year for equity investors. In its wake, investors abandoned the asset class in droves. Even now, volatility is keeping anxiety levels high, and many investors are wary of staying in – much less adding to – an asset class that has been responsible for so much wealth destruction in recent years. Against this backdrop of intense near-term uncertainty and unease, it is critical that advisors help their clients take a step back and remember their overall goals and what they are trying to accomplish over the longer term – and what they need to do to get there. Indeed, for many investors, “risk” is not so much the risk of loss in the near term as it is the risk of outliving their assets. As demographic trends tilt toward longer life expectancies (up to approximately 78 years today from just under 60 in 1930), people are spending more years in – in many cases staying active and thus needing more disposable income post-retirement. Despite their near-term volatility, in the long run equities are essential to keep up with inflation (which can eat into long-term returns), as seen in Figure 1 below.

Figure 1: Growth of $1 Invested in Various Asset Classes – January 1926-June 2010 ($) 100,000 Annualized Return US Small Company : 11.65%

10,000 US Large Company Stocks: 9.44% Traditional 60/40 Portfolio: 8.58% Long-Term Government Bonds: 5.55% 1,000 One-Month US Treasury Bills: 3.64% Inflation: 3.04% 100

10

1

0 1926 1938 1950 1962 1974 1986 1998 2010 As seen in Figure 1, while one-month T-Bills would have earned 3.6% over the time period in question in nominal terms, once inflation is factored in, investors would have eked out a mere 60 basis points on this investment. With regard to the merits of equity investing, investors also should not forget about the power of , which have accounted for almost half of market returns in the past 100 years. Dividends are cash in an investor’s pocket – money they can spend, invest, or save, and that they can receive without even having to sell a of stock. These are just a few points advisors can make to remind investors who may be bogged down in the stresses of the here and now that historically, over the long term, equities still make sense – and that depending on their investment time horizon, the risk of not attaining their goals may be greater if they don’t stay invested in this asset class.

Help Them Recognize That It’s a Cycle – and that a Bad Time in the Business Cycle Can Be Good News for Investors To economists, statisticians, and professional investors, the fact that markets are marked by cycles is obvious. Most individual investors also recognize this on an objective level, but when the economy seems to be languishing indefinitely in a trough, advisors may need to remind them of the market’s cyclical nature. At some point, we will recover, and perhaps the greatest long-term “wealth hazard” investors face is being on the sidelines when the cycle turns up because they panicked and moved into cash when things were bad. As Warren Buffet suggests, investors would be well served to “Be fearful when others are greedy, and be greedy when others are fearful.” Indeed, research points to the conclusion that times of market and economic uncertainty may actually be good times to invest for the long term, as counter-intuitive as it may feel to investors. To understand why this is true, we must first look at how investor emotions correlate to market cycles. page 2 Gerstein Fisher Research Paper The points on the sentiment cycle curve in Figure 2 on the opposite page more or less correlate with the movement of the business cycle. It is easy to understand why investors experience these emotions – quite naturally, they reflect on the recent performance of their . There is a tendency to extrapolate recent performance – good or bad – into the future.

Figure 2: Investor Sentiment and the Business Cycle

Peak Euphoria Sentiment Cycle Anxiety Business Cycle Thrill Denial

Excitement Fear

Desperation Optimism Optimism Recession Expansion Panic Relief Capitulation

Hope

Trough Despondency Depression At the same time, even a cursory look at this graphic reveals that our emotions can do us a disservice. For instance, if one invested at the first point of the graph, while being optimistic about the market, is it a good idea to add even more money at the point of thrill? Although it is not, that is what most people are likely to do.Similarly, being depressed about recent underperformance will lead most naïve investors to pull out of the market just when opportunity is actually highest. We decided to test this hypothesis and determine the numeric magnitude of this effect using data provided by the American Association of Individual Investors (AAII) – specifically, the Sentiment Survey and the Asset Allocation Survey. The Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the in the term; individuals are polled from the AAII website on a weekly basis. The Asset Allocation Survey polls members monthly on their current holdings among five asset categories: stock funds, stocks, funds, bonds, and cash. Obviously, the former measure is a direct reflection of investors’ emotional state, while the latter allows us to draw conclusions about their emotions based on the relative weights of stocks, bonds and cash in their portfolios. Figure 3 below depicts the relationship between the S&P 500 index and level of bullishness among investors:

Figure 3: Sentiment Survey Results vs. S&P Levels – 1987-2008 (%) 70 S&P 500 1,800 % Bullish 1,600 60 1,400 50 1,200

40 1,000

30 800

600 20 400 10 200

0 0 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Source: Standard & Poor’s, American Association of Individual Investors

Advising the Behavioral Investor: Keys to Helping Clients Stay Rational in Times of Market Turmoil page 3 On the one hand, we can see that to some extent, investor sentiment tends to follow the peaks and troughs of the stock index. At the same time, the relationship is (i) imprecise, and (ii) volatile. In this situation, the next step for us was to see whether this volatility could be used as a leading indicator of stock market returns. As researchers we are acutely aware of the trap waiting for anyone who attempts to manipulate past financial data to devise a precise strategy for the future – it simply won’t work. However, we were curious to see what might have happened if we bought and sold the S&P 500 at different levels of the Sentiment Index. Our model assumes that we invest $1,000 in the S&P 500 index in July of 1987; for simplicity, we exclude dividends from our analysis. We use one simple rule: if investor sentiment (as measured by AAII) reaches a certain level of bullishness (ceiling), we liquidate the entire portfolio and begin holding cash until the sentiment drops below another level (floor), at which point, we reinvest all cash back into the market. Shown below are several buy/sell threshold combinations simulated by the model. Shaded areas indicate that the model suggests moving out of the S&P and into cash during the period in question.

Figure 4: Sell/Buy on Any Change in Sentiment. Shortfall vs. Buy-and-Hold: (67.09)% 1,800

1,500

1,200

900 500 Price ($)

S&P 600

300

0 1987 1990 1993 1996 1999 2002 2005 2008

Source: Standard & Poor’s, American Association of Individual Investors

Figure 5: Sell on 60% Bullish; Buy on 60% Bearish. Improvement Over Buy-and-Hold: + 23.44% 1,800

1,500

1,200

900 500 Price ($)

S&P 600

300

0 1987 1990 1993 1996 1999 2002 2005 2008

Source: Standard & Poor’s, American Association of Individual Investors

page 4 Gerstein Fisher Research Paper Figure 6: Winning Combination: Sell on 67% Bullish; Buy on 50% Bearish. Improvement Over Buy-and-Hold: + 46.68% 1,800

1,500

1,200

900 500 Price ($)

S&P 600

300

0 1987 1990 1993 1996 1999 2002 2005 2008

Source: Standard & Poor’s, American Association of Individual Investors While these specific sentiment levels apply only to the historical data used in the experiment, a key takeaway of this exercise is that the more profitable of the simulated strategies were those that bought equities when sentiment levels were bearish (indicating greater perceived risk) and sold when they were bullish. Historically, however, investors have tended to follow their emotional hunches by changing their asset allocations at the wrong time, as we can see in the graph below where the first peak of cash allocation coincides with low S&P levels.

Figure 7: Average Cash Allocations of US Owners – 1988-2008 50 Approximate Cash Allocation (%) 1,600 S&P 500 Price ($) 1,400 40 1,200

1,000 30

800

20 500 Price ($) 600 S&P ximate Cash Allocation (%) 400

Appro 10 200

0 0 1988 1990 1993 1996 1999 2002 2005 2008

Source: Standard & Poor’s, Investment Company Institute For example, in 1987, sentiment was low and cash levels were high (near 35%) – right when the S&P was poised to take off on a 10+ year run. In other words, most investors were out of stocks for emotional reasons just when the growth potential was at its highest. Comparing the timing of the second cash allocation peak with the optimal configuration shown on the previous page, we can see that although the timing was close to optimal, the majority of investors did actually miss the lowest point – they would have achieved higher returns if they had started buying when the sentiment index stood at an unusually low level of 20%. Moving from investment assets to cash (or vice-versa) is not the only emotion-based allocation decision investors make. Investors also frequently chase returns, piling into sectors and asset classes that have exhibited strong recent outperformance. For example, in the late 90s and early 2000s, approximately $18 billion of new assets flowed into domestic growth equity funds, fueled by investor enthusiasm for the growth-dominated tech industry. In the three

Advising the Behavioral Investor: Keys to Helping Clients Stay Rational in Times of Market Turmoil page 5 years prior to their peak level of net inflows, US large cap growth stocks had returned over 14% annualized and had outperformed the global equity markets by almost 4% a year. As we now know, shortly thereafter, the dot.com bubble burst, wiping out trillions of dollars in market value over the next couple of years. When investors look to past returns to determine their investment strategy going forward, they often find themselves on the wrong side of the old adage to “buy low and sell high.” Indeed, Morningstar has found that the mutual fund categories with the greatest inflows tend to underperform those with the greatest outflows over the following three-and five-year periods.1The charts below show three asset classes – non-US equities, US large cap growth, and US large cap value – and their performance in the three years leading up to peak mutual fund flows into their respective categories (Figure 8) and in the one-year period following the peak (Figure 9).

Figure 8: 3-Year Trailing Returns From Peak Fund Flows Figure 9: 1-Year Forward Returns From Peak Fund Flows (annualized) (%) (%) 15 0

-5 12 -10

9 -15

-20 6

-25 3 -30

0 -35 Non-US US Large Cap US Large Cap Non-US US Large Cap US Large Cap Equity Funds Growth Funds Value Funds Equity Funds Growth Funds Value Funds

Source: Fund flow data from Morningstar. Index returns from Bloomberg. Non-US Equity Funds returns represented by MSCI EAFE Index; US Large Cap Growth Fund returns represented by Russell 1000 Growth Index; US Large Cap Value Fund returns represented by Russell 1000 Value Index. To put some context around these charts, flows into non-US equities peaked in June 2008, just when the US dollar had bottomed out. US large cap growth flows crested in January 2001 – right before the bursting of the so-called Internet bubble; and US large value funds, typically heavy in financial sector stocks, saw top inflows in August 2007 just before the credit crisis unfolded. What happened next is starkly portrayed in Figure 9, which charts the returns of these asset classes (as represented by their benchmark indexes) for the year following each one’s respective peak-inflow period. As this data shows, when investor emotion gets in the way, the impact on portfolio returns can be extremely damaging. If unchecked, sentiment will typically overshoot fundamentals, and greed will tempt investors to chase returns at precisely the wrong times. Presenting clients with hard data that clearly demonstrates how this is true – and how it can hurt them – can go a long way toward helping them make decisions that will serve them much better in the end.

Explain Why Risk and Return are Related – and Why It Matters Another pattern that changes with shifting economic conditions is investors’ risk taking behavior. When times are good, the emotion of greed kicks in and risk appetites grow; in bad economic times, however, investors will take on less risk – and demand more of a return premium for taking it on. The equity risk premium (ERP) exists because in any market environment, equity investors should demand a premium over a risk-free investment like T-bills since they are inherently more risky. Yet interestingly, between 2000 and 2008 the ERP has been negative – meaning that investors have actually been punished for taking on more risk. (See Figure 10.)

1 Morningstar Fund Flows and Investment Trends, Annual Report 2009. page 6 Gerstein Fisher Research Paper Figure 10: Historical Equity Risk Premiums (through year-end 2009) S&P 500 Return — T-Bill Rate = Market Premium Since 1926 9.70% — 3.60% = 6.10% Last 10 Years -0.80% — 2.50% = -3.30% Worst 10 Years of Depression -5.00% — 0.70% = -5.70%

While there have been several recent multi-year stretches where the ERP has been as bad as or worse than it was during much of the Great Depression, the good news in all of this is that it is not economically reasonable to assume that this relationship will persist indefinitely (if it did, there would no longer be a rationale for investing in equities). In fact, data has shown that long periods of essentially static prices and below-average returns have often been the precur- sor to extended periods of above-average returns. (Once again, reinforcing the message to investors that now is not a good time to be on the sidelines – unless, of course, they can predict with utter certainty when markets will turn around.) Reminding investors of such investing “laws of gravity” as , the cyclical nature of markets, and the fundamental relationship between risk and return may help them to place current events in a historical framework and thus make more sound decisions amid the noise and chaos of today’s markets.

II. Of Fat Tails and Black Swans: New Ways of Helping Investors Think About Risk The term “fat tail”, once rarified quant-speak for a rare and extreme event occurring on the far reaches of a normally distributed bell curve, has migrated into the popular vernacular and become a subject of much focus by academics, risk managers, and investment professionals alike. Fat tails have been in the spotlight recently mostly because we’ve been experiencing one – the global financial crisis – for nearly three years. Yet if we observe data going back to 1950, it turns out that stock market returns have actually been marked by more fat tail, or non-normal, events, than one might think. One example is October 19, 1987, when the S&P 500 fell 20% in a single day. The average move up or down over the past half century is 0.65%. By that measure, Black Monday was a 25-sigma event, meaning it was 25 standard deviations away from the mean. (To put this in perspective, the likelihood of this occurring would be less than winning the Powerball a trillion times a day every day for a trillion trillion trillion lifetimes.) Even ignoring Black Monday, if returns were “normal,” statisticians would expect the S&P 500 to move up or down by 3.5% or more only once every ten thousand years. In contrast, we’ve experienced 118 such occurrences since 1950 – nearly half of them in the past two years. Over the past two years, the average daily move up or down has been 1.3%. With that as a baseline, a normal distribution would see a fat-tailed move of 6.4% once every hundred years. In fact, it has already happened ten times in the past two years. Therefore, we have not simply entered an era with a “new normal,” when volatility will regularly stray outside the previous boundaries. The fact that we live in a non-normal world of fat tail is influencing the way that investors are thinking about risk and engaging in risk-taking behavior. In this section, we will take a closer look at what risk means today – and how advisors can help their clients accept and manage risk – and even make it work for them.

The Risks You Can Manage – and Those You Cannot “Events can move from the impossible to the inevitable without ever stopping at the probable.” – Alexis de Tocqueville

Definitions of risk abound in financial circles – risk of loss, volatility, liquidity risk, counterparty risk – the list goes on. An entire industry has grown up around the identification, quantification, and mitigation of every manner of investment risk. More robust risk management tools and platforms are available to investment and risk managers than ever before.

Advising the Behavioral Investor: Keys to Helping Clients Stay Rational in Times of Market Turmoil page 7 But at its core, for investors, what risk is really about is not having what they need when they need it – whether that is capital, or liquidity, or income. And somehow, even with an arsenal of state-of-the art risk management tools at their disposal, many investors can still be positively blindsided by risks they never saw coming – or never even imagined could exist. In the terminology of noted academic and bestselling author Nassim Nicholas Taleb, these are Black Swans. As Taleb defines it, a Black Swan is a highly improbable event with three principal characteristics: 1. It’s unpredictable; 2. It carries a massive impact; and 3. After the fact, we concoct an explanation that makes it appear less random, and more predictable, than it actually was.2 A Black Swan is a fat tail event of the greatest extreme. The terrorist attacks of September 11, 2001 are a good example of a Black Swan event. So how, investors may rightly ask, do you prepare for the kinds of risks you can’t even imagine?

8 Simple Rules to Help Investors Manage Risk in an Uncertain World While the uncertainty and volatility that characterize today’s investment landscape, as a rule, preclude the application of any sort of dogmatic risk management “formula”, when helping clients think about and manage risk today, some simple guidelines can be helpful to advisors. The eight points below deal broadly with risk management in the current environment, but several are specifically directed at Black Swan-like risks and fat tail events: 1. Prepare for What You Can – One way to manage risk in an uncertain world is to first focus on what you do know and can prepare for. For example, an advisor might recommend allocating the majority of his or her clients’ risk bud- get to those events that are deemed a) most likely and b) most damaging – for example the loss of a job, a significant market decline, or outliving their savings. A client may also wish to allocate a smaller portion of his or her risk budget to one or more low-probability events that could have a significantly negative impact (i.e. the Black Swans) – whether in the form of taking out insurance against such events as long-term disability or carving out an allocation to gold in case of 100% inflation, purchasing options, etc. 2. Diversify – This age-old recommendation remains as relevant as ever. Despite the fact that in times of market stress, cross-asset class correlations tend to rise, on a near-term basis, financial assets rarely move exactly in lockstep. Diversification still makes sense as a smart and relatively simple risk management tactic that can have a significant impact on long-term portfolio returns. Figure 11 shows the trajectories of two investments of $1 million each in the S&P 500 (dark green line) and a diversified, 10-asset-class portfolio allocated equally across 10 major US and global indexes and rebalanced quarterly. Following that is a chart showing annualized performance for each of these 10 asset classes over the period in question. As the chart shows, a naïve portfolio that simply allocated 10% to each of these 10 buckets (representing 40% fixed income and 60% equity and other risky assets) with quarterly rebalancing handily outperformed the all-eq- uity allocation. While correlations do tend to converge in times of stress, as noted earlier, over longer periods of time, being diversified globally and across asset classes still helps investors. Indeed, over the so-called “lost decade” for equities of 2000-2009, small cap value was up over 8%. Municipal bonds gained close to 5%. And the flight-to-quality mentality that dominated over much of the past 10 years pushed Treasuries up over 6%. 3. Be Cognizant of Systemic Risks – Perhaps ironically, all the financial engineering that sliced, diced and redistributed risk, presumably to provide market participants with more control over it, was a key contributor to the devastation that has roiled markets in recent years. Credit default swaps (CDSs) are a prime example of this. When one considers that the aggregate nominal value of worldwide financial derivatives is said to be $600 trillion versus global GDP of approximately $60 trillion, it becomes clear that nominal asset values are only the tip of the iceberg. When one counterparty in a complex chain of derivative contracts defaults, a domino effect of devastation can ensue. In a similar vein, investors who employed large amounts of leverage found themselves flat-footed when liquidity all but dried up.

2 Taleb, Nassim. The Black Swan: The Impact of the Highly Improbable. New York: Random House, 2007. page 8 Gerstein Fisher Research Paper Some systemic risks are bigger than the itself – for example the US government’s budget deficit and the precarious state of Social Security and Medicare funding. Given these strains, advisors can continue to emphasize a focus on liquidity for their clients for the foreseeable future. Advisors should consider counseling their clients to maintain a liquidity cushion, for example 12 months of living expenses in cash, so that if they do have near-term cash needs, they are not forced to sell financial assets in a down market. Indeed, the last thing we as investors want to do is demand liquidity when markets are in turmoil. Rather, we want to be in a to supply it – for example by taking depressed equity prices as a chance to buy instead of sell. Like water finding its level, liquidity will generally flow to where the opportunities are, and investors should be in a position to take advantage of that dynamic – not be penalized by it.

Figure 11: Impact of Diversification on Portfolio Returns ($) 2,250,000 S&P 500 Index – Annualized Return -1.59% 10-Asset-Class Portfolio – Annualized Return 6.12% 2,000,000

$1,810,700 1,750,000

1,500,000

1,250,000

1,00,000 $852,170 750,000

500,000 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Source: Gerstein Fisher Research, Ibbotson, Thomson Reuters, Bloomberg. 10-asset class portfolio includes a 10% allocation to each of the following: S&P 500, Russell 2000 Value, MSCI EAFE (net div.), MSCI Emerging Markets (gross div.), MSCI World Ex USA Small Cap (gross div.), Citi World Index 1-3 Years, Barclays Capital Muni Bond Index 7 Years; 5-Year Treasury Notes, Long-Term Gov’t Bonds, GSCI Commodity Index. 4. Don’t Try to Predict the Unknown – For months, market pundits and individual investors alike have been speculating on where we are in the economic cycle. Is the recession over? Are we headed for a double-dip? Proponents of the Efficient Market Theory would argue that investors’ time is not well spent trying to predict the unknown – that market prices are, on the whole, a reasonable approximation of fair value. Indeed, the data seem to support that most market prognosticators in fact do a poor job predicting future equity price performance based on past earnings. (See Figure 12 below.) As we like to say, price is fact; earnings are a prediction. And because investors are human beings subject to the so-called reinforcement bias, we tend to seek out facts that confirm our beliefs, not those that would refute them. Advisors would do well in reminding their clients of their own limitations in this regard. Figure 12: Standard & Poor’s Indices vs. Active Funds Scorecard, Q2 2010 For 5 Years Ending June 2010 Failure Rate US/Developed World Fixed Income Over 75% US Small Cap Equity Almost 70% US Large Cap Equity Over 60%

Source: Standard & Poor’s 5. Embrace Models, but Recognize Their Limitations – As discussed earlier, markets are dynamic, organic and uncer- tain. Models, by their nature, are cut and dried, and have distinct limitations if applied too rigidly. To paraphrase the American economist Milton Friedman, any economic model should be treated more like an engine of inquiry than a camera that simply reproduces empirical facts. Even when analyzing all available data, a model should allow for ambiguity and unexpected results, such as “fat tails”, and any investment strategy should avoid becoming so enamored of its predictions that it neglects common sense measures of potential risk.

Advising the Behavioral Investor: Keys to Helping Clients Stay Rational in Times of Market Turmoil page 9 6. Fight Your Instincts – Volatility makes most investors uncomfortable at best, and there is often a knee-jerk reaction to want to minimize it wherever possible. It is important to remind investors that near-term volatility can actually be the friend of the long-term investor by providing opportunities for rebalancing and building strategic portfolio positions. And as noted earlier, although correlations typically start to converge in times of crisis, different asset classes still tend to behave differently over shorter periods of time. This dynamic can be helpful with respect to portfolio rebalancing (“buy low, sell high”), or reaping the benefits of supplying liquidity to the market when it is needed most. Yet human beings tend to fear loss far more acutely than we hope for gain, and this aversion to loss often precludes us from taking advantage of the opportunities that volatile markets can offer. As 2009 began, deposits in passbook savings accounts and money market funds (the latter now guaranteed, in desperation, by the government) were greater than the of the entire US stock market, as denominated in the Wilshire 5000 stock index. For months on end – on any given day – the holders of cash equivalents earning less than one percent per year could have reached out and bought the American stock market in its entirety by nightfall. (So much for being greedy when everyone else is fearful.) One of the most valuable services an advisor can play is to help clients fight these instincts and stay focused and rational. 7. Understand How Your Strategy Works – It is human nature to be attracted to the “sure thing”, the positive returns, year in, year out, without wanting to ask too many questions. Yet the Bernard Madoff scandal brought to the forefront the importance of understanding where the returns you are earning are coming from. The days of the black-box manager are numbered – if not completely over. Investors have every right to demand transparency of process from their investment managers, and should settle for nothing less. Manager risk is very real, and the first step toward mitigating it is understanding the manager’s strategy and ensuring that the manager’s returns align with their stated objectives and process. Advisors should emphasize this to their clients and can be helpful in the process of evaluating manager processes and return streams to ensure their clients are getting what they signed up for. 8. Beware of Distracting Reference Points – Another behavioral pitfall into which investors can easily fall is “anchoring”, or the tendency to think about the value of certain investments in relation to an arbitrary benchmark like what they paid for them, or what they were worth at the market’s peak, rather than their continued merits as an investment based on their price today. Similarly, it is easy to allow one’s risk appetite to be influenced by recent events and experiences rather than one’s long-term objectives – for example retrenching and paring back on risk in the face of recent losses or piling it on while feeling confident in a strong market. And unless you live in a bubble, it is impossible to escape sensationalist news headlines announcing the “death of equities” or news that over the 20-year period ending February 2009, bonds actually outperformed stocks. These are the headlines that make the advisor’s phone light up with calls from anxious clients wondering how they should react. When investors obsess over this kind of static benchmarking, they can fall prey to a sort of tunnel vision that blocks out the reference points that really matter. For example, can I achieve my long-term goals? Am I making the best choice today based on those available to me? Etc. As advisors, we can and should help investors distinguish what really matters from what amounts to nothing more than distracting noise.

page 10 Gerstein Fisher Research Paper Conclusion: Managing Investment Portfolios and Investor Fears and Needs As financial advisors, we like to say that we don’t have people with investment problems; we have investments with people problems. Therein lie both the challenge and the opportunity for financial professionals today. If we can help our clients understand that the only thing we have to fear is fear itself, then we can approach their investment objectives from a place of shared understanding and commitment to getting them where they need to go – and help them to better weather the turbulence we might encounter along the way. A large part of this is education, including being able to translate theoretical concepts into practical applications in meaningful, relatable terms. Another is managing the behavioral/emotional component of the advisor-client relationship. Through the ups and downs the market will no doubt continue to experience, the advisor should recognize his or her critical role in helping clients retain clarity and reason when emotions might otherwise lead to poor decision making. The global markets will continue to be volatile in the future, and there will always be new surprises lurking beyond next quarter’s earnings reports. It is our unwavering belief that the proper role of an investment advisor is not only to intelligently navigate this volatility through careful portfolio design, but also to partner with his or her clients in adhering to their long-term investment strategies in a disciplined, objective way.

A publication by GersteinFisher an SEC registered investment adviser. All references to market performance was obtained from Bloomberg database.

The material presented is based on information and sources believed to be reliable but its accuracy or completeness cannot be guaranteed. There can be no assurances of the investment reaching forecasts or projections as outlined in this report. This analysis does not purport to be a complete study of the featured investment and any views expressed are as of the date hereof and are subject to change without notice. Readers should be aware that forward looking statements are subject to significant known and unknown risks and uncertainties, and other factors that could cause actual results to differ materially from expected results.

This report is for information only and is not intended as an offer or solicitation with respect to the purchase or sale of any investment, nor should any information or opinions expressed in this report be construed as investment advice. Investments mentioned herein may carry a high investment risk; and readers should carefully review the investments thoroughly with their registered investment adviser or registered stockbroker.

Research does not provide individually tailored investment advice. Research reports are prepared without regard to the individual financial circumstances and objectives of persons who receive them. The securities discussed in any report may not be suitable for all investors. An investor’s decision to buy or sell a security should depend on individual circumstances (such as the investor’s investment objectives, financial situation and existing holdings) and other considerations. Gerstein Fisher recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of one of our advisers. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.

Please remember to contact Gerstein Fisher if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/ evaluating/revising our previous recommendations and/or services, or if you want to impose, add, or to modify any reasonable restrictions to our investment advisory ser- vices. Federal and State securities laws require that we maintain and make available current copies of our Registered Investment Adviser Disclosure Document, also known as Form ADV Part II. Pursuant to SEC Regulation S-P, Privacy Notice can be found at www.GersteinFisher.com or you can contact our office and request a copy.

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Advising the Behavioral Investor: Keys to Helping Clients Stay Rational in Times of Market Turmoil page 11 phone: 212-968-0707 [email protected] www.GersteinFisher.com