CONFERENCE CALL — NEEDED ON THE STREET: DOSE OF REALITY

Bubbly exuberance, as opposed to the irrational kind feared by the Fed’s Alan Greenspan, plagues financial planners and investors, who are also riddled with “overconfidence” and an “illusion of control,” says a top behavioral psychologist.

People underestimate the uncertainty of the real world, and thus become more cocky than they realize, says Daniel Kahneman, the Eugene Higgins professor of psychology at Princeton University.

“I wouldn’t want my financial adviser to be overconfident. That might be costly,” he says. “I might want him clinically depressed.”

Mr. Kahneman made his remarks earlier this month at the J.P. Morgan & Co. symposium for financial planners at the bank’s Wall Street headquarters. His speech came at the end of a grueling day in which experts like famous California academic and money manager Barr Rosenberg expounded on market neutral investing and others, such as Jean L.P. Brunel, chief investment strategist for private clients worldwide for J.P. Morgan, debated the efficacies of passive and active styles for tax-efficient investing, and the use of alternative investments. All to find a way to control the risk of a client’s portfolio. How. . . confident of them!

Instead of feasting on free drinks and dinner at the tony Windows on the World atop the World Trade Center, the 70 or so financial advisers who attended the confab might have been better served by a splash of cold water.

As evidence of the human tendency toward cockeyed optimism, Mr. Kahneman cited studies showing college students inevitably insist they will be more successful than their roommates, despite the reality that they have no idea. Indeed, most even believe their roommate has a better chance of contracting cancer than they do.

Another study showed that people exaggerate their own skills “even when you beg them to be accurate,” he says. He says 80% to 90% say they are above the median in various desirable skills from driving to having a sense of humor.

Worse, people fool themselves into believing that because they understand why certain events may have triggered something — say, the fall of a stock price — that those events were inevitable. “By denying the true uncertainty of the past, we are also denying the uncertainty of the future,” Mr. Kahneman says.

Here’s how irrationality plays out in the stock market.

packaging counts

People have a preference for gambles they perceive as sure gains or long shots, but almost never somewhere in between. In one study, subjects said they would not risk $2,000 on a 90% chance of losing everything, if they were also given a 10% chance to win $118,000. But they were willing to make the bet if it was phrased this way: Would you invest $2,000 for a 10% chance to win $120,000, but a 90% chance to lose the $2,000?

The gamble becomes more attractive if the potential loss is perceived as an up-front cost, even though the risks in both scenarios are equivalent, Mr. Kahneman says.

Planners did not dismiss Mr. Kahneman’s lecture. Indeed, behavioral finance, around for years, has become a trendy topic of discussion and research among planners. Some are working with psychologists to help them better examine the investment characteristics of their clients.

beyond risk tolerance

Calling behavioral finance, “the new frontier of our business,” financial planner David Diesslin of Fort Worth, Tex., says he and a psychologist are experimenting with a questionnaire intended to help him probe beyond merely determining risk tolerance. Instead, Mr. Diesslin, whose firm, Diesslin & Associates Inc., supervises the assets of 250 clients, is delving into the motivations behind various investment decisions. Ten clients recently agreed to fill out the questionnaire which he sends back to the psychologist to examine, he says.

“From my perspective I don’t want to get into the business of counseling, but to get into the business of better understanding the client,” he says.

Nothing frustrates financial pl
anners more than spending energy and time trying to figure out a client’s risk tolerance only to learn later when markets get volatile that the client is far more risk-averse than expected. “Anything you can do to get a better handle on what’s going on in your client’s head is good,” says Harold Fletcher, who heads Investment Counsel & Trust Co. of Memphis, which oversees $100 million.

Meanwhile, across the street from J.P. Morgan, the New York Stock Exchange was humming along.