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| A Top-Down Approach to Behavioral Finance |
| by
Michael M. Pompian
| 10-15-09 |
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In the past eight years, we have seen two of the four worst bear markets of the past 100 years. At the March 2009 lows, upward of $15 trillion in asset values had evaporated, wiping out capital gains earned in the bull markets of the 1990s and 2000s. Many clients were shell-shocked, often frozen like deer in the headlights as to what to do. Basic risk-tolerance questionnaires failed to profile adequately the true character and needs of clients. Understanding how investors make investment decisions is no longer a nice-to- have skill. In this new era of wealth preservation, financial advisors are now required to be able to diagnose irrational behaviors and biases and advise their clients accordingly.
Behavioral finance--generally defined as the application of psychology to finance--gives advisors insights that can help them gain a deep understanding of how to build strong relationships with clients. Although advisors have different ways of measuring the success of a client relationship, few could argue that every successful relationship shares fundamental characteristics. Consider the ways behavioral finance improves advisory relationships.
How Behavioral Finance Helps Clients
One characteristic of a good relationship is understanding a client's financial goals. To best define goals, it is helpful for advisors to understand the psychology and emotions underlying the decisions clients make when creating the goals. Such insights equip the advisor with tools to deepen the bond with the client, producing a better investment outcome and achieving a better advisory relationship.
Advisors who maintain a consistent approach to delivering their services build professionalism and structure to the client relationship. Incorporating behavioral finance can become part of that discipline. Advisors can use behavioral finance to get to know clients--even classify them--before offering any actual investment advice. Advisors will learn which approach with each client works best, and they can consistently apply that approach. Clients benefit because they know what to expect from their advisor.
Addressing client expectations is an area of the advisory relationship that can benefit most from what behavioral finance has to offer; it is essential to a successful relationship. Younger advisors often fail in this area because they don't take the time to understand the needs of the client. Behavioral finance provides a context in which the advisor can take a step back and attempt to understand the motivations of the client.
Many top advisors across the globe are applying behavioral finance to their practices. In August 2007, I surveyed 290 sophisticated financial advisors(1) in 30 countries. I asked them about their knowledge and use of behavioral finance. Ninety-three percent of advisors surveyed reported that they were aware of key behavioral-finance biases, and 94% were using behavioral- finance principles with their clients. Some less-experienced and quantitatively oriented advisors, however, are still needlessly struggling with understanding their clients' behavior. This article introduces a foundation of basic behavioral-finance principles and will give advisors a step-by-step guide to incorporating behavioral-finance techniques into their practices.
(1) In order to be "eligible" to receive a survey invitation, advisors needed to have some kind of advanced professional or academic designation--an MBA, CPA, CFA, CFP or other professional accomplishment.
Macro to Micro
Breaking Behavioral Finance Down
Perhaps one hindrance to behavioral finance being widely used in advisory practices is a lack of a common understanding of what it is. There is a proliferation of topics resembling behavioral finance, such as behavioral economics, investor psychology, cognitive psychology, behavioral science, experimental economics, and cognitive science. To make behavioral finance easier to understand, and to differentiate the study of individual investor behavior from market behavior, I adopted an approach favored by traditional economics textbooks. I broke down the subject into two subtopics: micro and macro.
Behavioral finance micro examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory. Behavioral finance macro detects and describes abnormalities in the efficient market hypothesis, such as technical and calendar anomalies.
As financial advisors, our focus is on BF micro.
We want to identify relevant psychological biases and investigate their influence on investors' asset-allocation decisions so that we can manage the effects of those biases on the investment process.
Each of these two subtopics corresponds to a distinct set of issues within the discussion of standard finance versus behavioral finance. With BF macro, the question is: Are markets efficient or are they subject to behavioral effects? With BF micro, the question is: Are individual investors perfectly rational or can cognitive and emotional errors affect their financial decisions?
It is critical to understand that much of today's economic and financial theory is based on the notion that individuals act rationally and consider all available information in their decision-making process. Academic researchers, however, have documented abundant evidence of irrational behavior and repeated errors in judgment by human subjects.
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| Michael M. Pompian, CFA, CFP is an investment consultant to family offices and is based in St. Louis. His book, Behavioral Finance and Wealth Management, is helping thousands of financial advisors globally build better relationships with their clients. |
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