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The Incredible 'Shrinking' Advisor

By Bruce Love August 8, 2016

This is part one of a three-part series on the practical uses of behavioral finance. This article covers how advisors are using behavioral finance. On Tuesday part two will investigate how different principles can apply to different wealth segments. Part three on Wednesday, August 10, will identify potential problems with behavioral finance and its place in the regulatory framework of advice.

You can’t ignore how people think about money – the mental accounting they do by psychologically putting money into different mental buckets. One bucket for retirement, one for vacations, a couple for kids and college, and so on. Advisors need to respect those thoughts and understand they shape how investors intrinsically make investment decisions.

At least that’s Drew McMorrow’s belief. The CEO of Ballentine Partners in Waltham, Mass., is one of a growing number of wealth advisors who ascribe to behavioral finance.

McMorrow, whose firm manages $5.9 billion, believes this idea so much he uses an algorithmic representation of mental accounting to fit his client’s aspirations into an investment strategy. Different portfolios represent different goals, each with varying degrees of risk and asset allocation makeup.

McMorrow says it helps investors understand and confront their behavioral biases when it comes to investing. If someone is loss averse, they can better deal with market downturns if only one or two of their “buckets” are affected.

At Ballentine, the mental accounting model isn’t the only application of the field. All McMorrow’s advisors are trained in the basic tenants of behavioral finance and are able to use them in their conversations with clients and in understanding their application in portfolio construction.

When advisors think of behavioral finance, McMorrow says they often think of behaviors which need to be curbed, such as overconfidence or loss aversion.

But, he says, “we didn’t get where we are as a species by ignoring our gut. Loss aversion helped us avoid predators, and it shapes the investment industry.”

On the other hand, risk-averse investors worry about things like volatility. “But volatility is your friend,” says McMorrow. “If it wasn’t for volatility, you wouldn’t get the big returns.”

Michael Liersch

These volatility-phobic investors often ask Michael Liersch, head of behavioral finance and goals-based consulting at Merrill Lynch, how they can become more risk tolerant. His response is, “Why would you want to do that? If you have the capacity for risk – and risk is required – then it is appropriate to take that risk.”

Loss aversion, overconfidence, mental accounting, anchoring, confirmation bias, hindsight bias … the list of new terms to describe investor behavior seems endless. But where do these ideas come from? Are they simply pseudo-scientific ways of articulating common-sense ideas about investing, or is there robust research and meaning behind them?

Nicholas Barberis, professor of behavioral finance at Yale University, says researchers have been doing a lot of work over the past 10 to 15 years, using modeling and analysis of large data sets, to try to figure out the most important psychological principles that govern investor behavior.

“We still don’t know for sure what these are,” admits Barberis, “and the consensus might be different in 10 years’ time,” but they nonetheless form a useful framework for advisors to think about – and communicate – the investment behaviors of their clients.

Much of behavioral finance rests mainly on the work of two psychologists – Nobel laureate Daniel Kahneman and Amos Tversky – and economist Richard Thaler. Kahneman and Tversky from the 1960s, and Thaler since the 1990s, explored the psychology of judgment and decision-making in the context of economics and finance.

Systematically academics have built these frameworks into something on which some advisors feel they base their practices.

“Most wealth management advisor’s practices revolve around selling investments,” claims Jordan Waxman, managing partner of New York-based HSW Advisors, a HighTower team. “Some do financial planning but it is usually after the data for the investment strategies has been analyzed. In my practice, I don’t get involved in the analytics. Instead I spend all my time talking to clients about their goals — what they want to do in their lives and families. I live and breathe this dialogue, as it is a leading aspect of getting to the psychology of an investor’s decision making.”

From this deep dive into his clients’ lives, Waxman says he creates an understanding of the family’s goals, translating that into asset-allocation decisions. “It’s critical if you want to provide people with the financial position they require to fulfill their life’s goals.”

At the center of Waxman’s process is what he sees as a deep understanding of how to apply behavioral finance. Investors usually think and talk in terms of emotion, he says. He’s noticed that often all clients are thinking about when they talk about a particular stock is the price at which they bought in and the price at which they want to sell.

“This creates lopsided portfolios,” says Waxman. “It’s the advisor’s job to work out which emotion is driving the investor and assess its impact on their decision-making – and, ultimately, the portfolio makeup.”

The market is based on a myriad of emotional decisions and gut reactions, and “ultimately for the investor, that’s the usefulness of behavioral finance.” says Merrill’s Liersch, adding that behavioral finance gives his employer’s brokers a way to make sense of what drives their clients.

Within Merrill’s extensive behavioral finance toolkit are some simple preference questions to get clients thinking. “The act of questioning themselves helps people to internalize their goals,” says Liersch. “Acknowledging that an investor has preferences and biases – that’s what behavioral finance is trying to do.”

He trains the firm’s advisors to use behavioral finance as a practical tool rather than a theoretical approach. But that doesn’t mean a deep analysis of people’s decision-making is needed at every turn.

“The process should begin with, ‘When should I think deeply?’ For instance, if a decision has the potential for more severe consequences, then it should be put through a more rigorous decision-making process,” says Liersch. “Otherwise, by all means, feel free to use your gut.”

But even getting to the point where investors and advisors alike can consciously analyze such thought processes requires an above-average level of self-awareness, says Liersch. It’s not something you can do without training.

Michael Brady, president of Generosity Wealth Management, a Boulder, Colo.-based firm managing around $50 million, says advisors also need to have very close relationships with their clients as well as solid training in behavioral finance if they are to use it effectively.

“Advisors need good two-way communication right from the very beginning so that they can ask the tough questions and push back when a client might be feeling emotional, might be asking emotional questions,” says Brady.

One way advisors can guard against bad decision-making is to discuss with clients the nature of volatility and market declines. “Advisors need to have a good dialogue with their clients, warning them that at some point it is normal for business cycles to go down,” says Brady. “Advisors should talk to their clients in advance about what they might do when that happens, so that you have a plan in place and an understanding of why you’re making certain decisions.”

When clients get emotional sometimes it’s necessary to push back on a client’s proposed play, says Brady. But reframing an emotional question in a less emotional way is much easier if you’ve already put in the groundwork with the client, he says. “Through working together, discussing possible strategies, and introducing the client to the different ways emotions and behavior can impact their investment decision-making, you can improve the way they invest. But that can only happen if you’ve already built up trust and exposed them to behavioral finance.”