Finding a client's investment attitude is no easy task. Just ask any advisor. But knowing what an investor wants and how his or her feelings color decision-making is becoming more crucial in the increasingly competitive world of attracting and retaining high-net-worth clients.
While several financial companies are embracing the idea of behavioral finance, Barclays Wealth Management is one of the leaders in applying it to the real world. The firm has pinpointed more than 1,200 distinct investor-personality types along with specific strategies for advisors on how to relate to them.
Barclays recently unveiled its new approach to understanding clients better and delivering advisory services best suited for them. Toward that end, the company's team of psychologists and behavioral experts has spent the past four years developing and refining a questionnaire. It is designed to gauge investors' attitudes toward the markets, risk and financial decision-making. To date, more than 10,000 clients and prospects across the world have taken the test.
At UK-based Barclays, its behavioral team, in London and the U.S. (and soon to expand to Asia), spent an enormous amount of energy connecting the academic concepts of behavioral finance to clients' portfolios. " We try to address each person individually instead of typecasting," says Michael Liersch, VP, of behavioral finance and investment philosophy for Barclays Wealth. "In the Americas, we started rolling it out in 2009. "Reps started taking the test in 2009. We train them and have them internalize the concepts."
The firm's questionnaire measures six aspects of a financial personality. There are three risk attitudes: risk tolerance, composure and market engagement. Then there are the three decision-making styles: perceived financial expertise, desire for delegation and belief in skill. Each is measured along a sliding scale and taken together they illuminate an individual's unique financial personality. The goal is to give advisors a more fine-grained assessment of the client's mindset when to comes to money, Liersch says. For example, a client could genuinely have a high-risk threshold over the long-term, yet still be prone to impulsive selling during short-term market turmoil. In that case, he would have high risk tolerance, but low composure, says Joseph Dursi, vice president in Barclays Portfolio Consulting Group. Dursi's unit builds customized portfolios using the insight gained from the questionnaire as well as the client's overall situation and objectives.
That type of client is not unusual. Entrepreneurs are often in that category, Liersch says. They are not averse to taking risk, obviously, because they have put their own capital at stake. But they are also focused on the short-term as a result of the day-to-day oversight of their companies.
While that can be good for an entrepreneur, it makes for an antsy investor. They often will end up selling at a low point.
Using traditional methods, that client would have been identified as having a high risk threshold and would likely have been put into volatile investments. And just as likely, he would have conveyed his low composure just after the market dipped 5% the first time.
Barclays Wealth would have suggested using managers who exhibit good "downside capture," that is, those who do well in bear markets. Another options would be the use of structured notes to smooth returns, Liersch says. "When you look at the academic community, behavioral finance has become very well respected; we wanted to get ahead of this and offer it to clients."
Dursi notes that in the past few months, Barclays has gained clients who had made those mistakes and grew frustrated with their former advisors.
The process of constructing a unique portfolio for a client takes personal situations into consideration too. For instance, if a client owned a sugar plantation, the test would ratchet down its commodity suggestions and put a premium on stability to help offset the risks in the client's business. While a recommended allocation for commodities might range between 3% and 6%, in this case Barclays Wealth might recommend a 1% or smaller direct exposure to commodities. It also would also suggest a decrease in overall portfolio risk.
This process benefits both advisors as well as clients, Liersch says. It helps form a long-term relationship, or, in the case of a prospective client, it enables advisors to "walk in their shoes." Whereas in the past it may have taken years to identify a problem, now Barclays can understand someone's financial personality in an hour, he says. There would, however, still be several meeting beyond that point to come up with the solutions.
Another common scenario is a high-net-worth husband and wife or partners who invest together but have misperceptions of each other, Liersch says. "When you are dealing with two clients who are working together but not communicating with each other, it inhibits the advisor from being able to better serve the client," Liersch says.
In the case of one couple, one partner was very low in perceived financial expertise and as a result, wasn't confident. The other partner was just the opposite and came to dominate the decision-making for the portfolio. The less confident "partner never spoke up, but just stayed up late at night worrying about the portfolio and was unhappy with the portfolio movements," Liersch says. After the couple took the assessment test, they moved toward a more moderate portfolio that both liked.
Hit Or Miss
Years after making its debut as a fringe element in institutes of higher learning, the acceptance of behavioral finance in financial institutions is still a hit-or-miss proposition. It can be used broadly in two ways, says Harold Evensky, president of Coral Gables, Fla.-based advisory firm Evensky & Katz. One is to find investment opportunities when the entire market has acted irrationally and mispriced stocks or bonds. The other is to try to improve practice management by identifying flawed decision-making.
It's the latter that has applications to financial advisors, but it is still proving devilishly difficult to apply in a concrete way, says Geoff Davey, co-founder and director of Australia-based risk profiling company, FinaMetrica. The challenge, Davey says, is that while behavioral finance reaches interesting conclusions about people as a group, there is still a wide range of individual differences within that group, he says.
Another company that's making headway is Allianz Global Investors, which created a Center for Behavioral Finance last summer. A board of academics is shaping the overall strategy, but it's up to Cathy Smith, co-director of the center, to implement these concepts in the real world of people and money. "The past two decades have given everyone the notion that we're missing something, and that something is human behavior," Smith says. "We're taking this from the ivory tower to the office tower."
Many of the concepts in behavioral finance are "deceptively simple," she says. One that has resonated in the real world calls for committing a higher allocation of money to a 401(k) before a pay raise. There is no immediate pain in the way of less take-home pay, so the idea is more palatable for most people, she says.
That idea was dubbed "Save More Tomorrow" in a report that helped reinforce the importance of behavioral finance to Allianz, Smith says. The center is not just about retirement but rather the full lifecycle, she says.
Allianz is in the process of writing a white paper that will deal with the challenges advisors are facing, Smith says. She says they informally call it "Behavioral Finance 2.0" since it will take this beyond research and observation and actually improve financial outcomes for people.
One challenge faced by advisors now is a lack of trust, she says, which also relates to behavioral finance. A lot of advisors feel that they have just one more chance to regain that trust or risk losing clients for good. Yet they are paralyzed because they are more fearful of making a bad decision that will cause a client to leave than they are hopeful of doing well and gaining that client's support. A behavior specialist might say they suffer from their own form of "regret aversion." So Allianz's center is working with advisors to help overcome that reluctance. One such way might be to get an advisor to commit to an invest-for-tomorrow plan, Smith says. This would be similar to "Save For Tomorrow," but advisors would be convincing clients to move cash gradually to longer-term investments over time.
Others back up the idea that there is reason to worry about the fragile issue of trust. Studies have shown a direct correlation between trust in a society and GDP growth, says Richard Peterson, Managing Director of consulting firm MarketPsych. And in the U.S., trust in the financial industry has been on a decline for 22 years, according to Peterson's research. MarketPsych uses a linguistic analysis to measure trust in the market by monitoring conversations on social media websites, financial blogs and chat rooms (up to 200,000 conversations per day). There appeared to be an uptick in trust in October, but then it fell again in November when news of mortgage foreclosure scandals broke, he says. His trust work is an offshoot of his behavioral research, which also uses a linguistic analysis to identify buying opportunities in the stock market.
Another tool from behavioral finance that advisors can use to effectively deal with clients is "framing," says Robert Seaberg, managing director and head of Wealth Advisory Resources at Morgan Stanley Smith Barney. Framing is the way that an investment or any issue is presented to an audience and how that presentation can affect their perception of the subject.
Seaberg uses annuities as one example. When dubbed "investments," 75% people won't want to buy them; but when they're described as "income," they elicit the opposite effect: 75% want them. There is an element of the advisor's job that is similar to a therapist, he says. In framing conversations with clients in various ways, he encourages MSSB's advisors to engage in their own experiments to see which strategies work better. "Human beings are not rational, they do things that are irrational, even incompetent, and that affects markets." One example is holding onto to losing stocks too long, he says.
Indeed, even Evensky, from Evensky & Katz, which advises behavioral pioneer Daniel Kahneman, acknowledges falling victim to the framing trap. For example, Evensky's client newsletter used to stress the importance of long-term investing, yet it showed performance for just the last quarter or two. That, Evensky says, misframed the issue for clients. Another mistake: He used to highlight his performance relative to the S&P 500, even though he wanted the message to be one of positive gains.
Now the newsletter benchmarks against inflation, and it doesn't give short-term performance data.
Evensky says that falling into the behavioral pitfalls is not an indication of intelligence or sophistication. It's just flawed human nature, and everyone has the same, misguided tendencies when it comes to money. Now when a client comes in excited about some idea, "we listen while they wax poetic about whatever it is," Evensky says. "But then we ask them what the pitfalls may be." This forces the client to consider the possible negative side. In other words, they are now framing the issue appropriately.
The Nobel Nod
Some experts scoff at the notion that behavioral finance is too esoteric to be useful. "I've heard this idea a lot, and I think it's funny," says Duke University Professor of Behavioral Economics Dan Ariely, one of the main proselytizers of behavioral finance. He says people naturally use the ideas behind behavioral finance. "Everyone uses psychology, even if they pretend they don't," he says. "Investors naturally think that they know more than other investors," he says, invoking one of the ideas that behavioral science warns about-overconfidence.
Ariely even questions whether financial institutions have an incentive to delve into behavioral finance and help clients improve decision-making. He maintains that they benefit from opaqueness in the market because it helps them convince clients of the value they add.
Regardless of its application, behavioral finance has been kicking around the halls of academia for a couple of decades. Herbert Simon, a professor of computer science and psychology at Carnegie Mellon, won a Nobel Prize in Economics in 1978 for his work in decision making. But it wasn't until psychologist Daniel Kahneman won the Nobel in Economics in 2000 that these ideas really began to gain traction.
And it was about that same time that the pieces were coming together for what would become Barclays' foray into this field. While still in school, Greg Davies had become intrigued with the ideas that would come to form Barclays Wealth's behavioral business. Davies studied economics and philosophy and became fascinated with the assumptions of rationality in economics. He worked as a consultant for short time, but then returned to school for a Ph.D degree. At the time, he assumed he'd end up in academia, but he soon became convinced that he could make this applicable to financial firms. Eventually, he realized that the piece he was missing was psychology.
So he finished with a degree decision theory and behavioral finance, and then started making his pitch to banks: He could apply behavioral finance to their business model in a concrete way. It was by chance that he was called by a headhunter to talk to Barclays, he says, but when they met a little over four years ago, their ideas meshed. He was hired as Head of Behavioral Finance at Barclays Wealth and given the task to hire a team and lead the behavioral charge.
While Barclays and Allianz are among the companies trying to help improve their customers' decision-making process by clarifying irrational tendencies, some other companies are attempting to gain from it in other ways. The other side of this behavioral finance coin is making money by buying the stocks that everyone else is dumping for no good reason. But even here, there are lessons for financial advisors.
JPMorgan Asset Management has $35 billion invested globally with behavioral strategies. About $10 billion of that is in the U.S., some of which is within the Intrepid family of mutual funds. Christopher Blum, Managing Director and Chief Investment Officer of the U.S. Behavioral Finance Group at J.P. Morgan Funds, says the strategy is to exploit irrationality in the market place.
Blum suggests that advisors and their clients determine specific goals, and, just as important, write them down. One of the hardest things for an investor to do (and it falls squarely under behavioral irrationalities) is to sell stocks when they should. But sell decisions are easier if you have rules, Blum says.
In fact, the simple act of writing something down is a good strategy much of the time, says Blum's colleague Theodore Dimig, a fund manager on the behavioral finance team at J.P. Morgan. "If a client comes in and says, 'Convert everything to cash,' one good technique is to ask them to write you a note and send it to you," Dimig says. "It will turn on the logical part of their brain," and cause them to act less rashly.
At Barclays, it's viewed in generally the same manner: a tool to help clients make more sound decisions. And in the process, it helps create a stronger bond with clients. "Current clients may be working with a number of banks," Liersch says, "and we many not become their only bank, but it strengthens our relationship with them because we need to know more about them.
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