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Behavioral Finance: It’s Not Just for the Wealthy

By Bruce Love August 9, 2016

This is part two of a three-part series on the practical uses of behavioral finance. This article investigates how different principles can apply to different wealth segments. Yesterday part one covered how advisors are using behavioral finance. Tomorrow part three will identify potential problems with behavioral finance and its place in the regulatory framework of advice.

Behavioral finance is often heralded as a revolutionary breakthrough in investment thinking. It is used by financial advisors large and small to help them better understand their clients and construct more suitable portfolios customized for their individual and family goals. But are the principles of behavioral finance equally applicable to clients of all net worths – from retail all the way up to ultra high-net-worth clients?

There actually haven’t been very many peer-reviewed studies on the applicability of behavioral finance across wealth segments, says Nicholas Barberis, professor of behavioral science at Yale University. But he thinks some evidence suggests that it is similarly applicable.

“We know that many institutional investors exhibit similar mistakes to retail investors – just to a lesser degree,” says Barberis. “And studies in other contexts show that highly-trained professionals demonstrate the same psychological traits as less-experienced individuals. For instance, top professional golfers exhibit loss aversion in the shots they take, just the same as amateurs.”

Similarly, Barberis doesn’t think there are necessarily different principles for different demographics.

Barberis says the basic behaviors — such as loss aversion and overconfidence — probably stem from psychological processes that developed over the very long span of human history and are thus firmly embedded in our thinking.

But he notes some cultural differences. “Catholics seem to be more drawn to lottery-like investments – not because they have a different psychological make-up, but because the Catholic Church is more permissive regarding gambling. And some cultures, such as Asian cultures, seem to exhibit certain biases less, which may have an impact on investing behavior.” For instance, some academics argue that Chinese investors are more prone to overconfidence and something called the disposition effect in which they are more likely to sell well-performing stocks but not poorly-performing stocks.

Jordan Waxman is managing partner of HSW Advisors, a New York-based HighTower team. He thinks there are significant differences in the general motivations of clients at the top end of the market. Waxman says ultimately ultra high-net-worth clients – those with more than $25 million in investible assets – are usually more interested in minimizing risk and “want someone to listen to them.” If an advisor at that level wants a robust relationship with the families they’re serving – and wants to be relevant – then Waxman says it’s important to understand how wealth preservation needs determine investment behaviors.

High net worth clients, on the other hand, are more about wealth maximization. Those clients with $1 million to $25 million are fixated on growing their portfolios. Those two differing goals, says Waxman, can lead to intrinsically different behaviors.

To understand his clients, who are predominantly at the high end of the market, Waxman employ values-based planning, which is the process of identifying the family’s core values and expressing them in a financial plan.

“I find out and explore a family’s early experiences of money issues – where they come from, what moves them and what messages they receive about money,” says Waxman. “Then I translate those experiences into their values and can drive their behaviors towards money.”

From those values Waxman says he creates a code of conduct for the family. “These are the best practices in transferring wealth from generation to generation.”

Another firm at the high end which has embedded behavioral finance into its business model is Ballentine Partners, a Waltham, Mass.-based firm which services 170 ultra high-net-worth families and manages $5.9 billion.

“The whole focus of the business is on families and how they can achieve their goals, says the firm’s president Drew McMorrow.

Behavioral finance is so intrinsic to Ballentine’s business that the firm has a family wealth psychologist on retainer, providing advisors with training and consulting on family dynamics.

“Behavioral finance helps us understand how people are hard wired to make financial decisions,” says McMorrow.

For instance, McMorrow says some new money clients are more comfortable using a dollar-cost average method of investing, where on a regular schedule the advisor buys a fixed dollar amount of a particular investment, regardless of the share price. More shares are bought when prices are low, fewer shares when prices are high.

“It’s actually worse but for some new investors it makes a big difference psychologically,” says McMorrow. “We let them know what we’re suggesting and why.”

Michael Brady

Michael Brady, president of Generosity Wealth Management, a Boulder, Colo.-based firm managing around $50 million, says he implements behavioral-finance techniques and communicates them to every client or prospect who walks in the door, regardless of how big or profitable they might be. His clients mostly range from mass affluent to high net worth.

“I feel it’s an investment up front that has many dividends for many years,” says Brady. “If it’s a smaller client I still spend all that time, because serving potential issues down the track will cost more than spending the time right up front.”

Brady says for his clients, it’s the basics of behavioral finance which can prove the most advantageous – like understanding how emotions affect investment decisions.

So while academics like Barberis say the essentials of behavioral finance are likely applicable across all wealth segments it seems likely there are some key differences behind the motivations and behaviors that advisors might encounter at varying wealth levels – and at the higher end of the client base, the opportunity to apply more complex methods of helping clients counter their own specific bad behaviors and beliefs.