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Behavioral Finance is no Panacea for Advisors

By Bruce Love August 10, 2016

This is part three of a three-part series on the practical uses of behavioral finance. This article identifies potential problems with behavioral finance and its place in the regulatory framework of advice. Part one on Monday, August 8, covered how advisors are using behavioral finance. Yesterday part two investigated how different principles can apply to different wealth segments.

As behavioral finance gains increasing popularity among financial-advice processionals, some practitioners warn it is no panacea, and indeed there are dangers in misapplying it when advising clients.

Behavioral finance is the so-called science of understanding how humans make financial decisions. Increasingly it is being used as the underlying philosophy for investment platforms and goals-based allocation methods. But Nicholas Barberis, professor of behavioral finance at Yale University, fears that sometimes advisors and academics can be too casual or too quick when trying to diagnose the root of someone’s investing behavior. He hears practitioners say, “That’s obviously overconfidence,” or “What you’re doing is showing loss aversion.” But Barberis warns that “the only way we can really know what’s going on is by testing our hypotheses carefully on large data sets. It’s only through that kind of work that we can make valid statements about the psychological drivers of investment behavior.”

Another problem Barberis encounters is that financial advisors themselves sometimes have faulty intuitions about investing. “A recent study of the investment portfolios of financial advisors in Canada found striking evidence of this,” he says. “The advisors made investment mistakes that mirrored those of their clients.”

But the main practical challenge for advisors is that even if they can successfully identify the faulty thinking behind an investment decision, it’s hard to know how to change it, says Barberis.

“People have wrong-headed intuitions about how to invest, but these intuitions are often strongly held and hard to change,” Barberis says. “As yet there haven’t been many rigorous studies of interventions that can help people overcome their investment biases.”

Over the next few years, Barberis foresees more academic research leading to tangible and practical benefits to wealth management. “The past 15 years have been focused more on understanding the problem, rather than on finding solutions. But further work is on the way.”

Many financial advisors have developed their own techniques for coaxing clients out of faulty thinking. If, for instance, a client is reluctant to close out a trade at a loss, it can help to talk about “transferring” the funds to another investment. “But there haven’t, as yet, been many systematic tests of these interventions,” says Barberis, who sees a danger in advisors assuming behavioral finance theories are certainties that can translate into clear solutions. “While many investors appear to over-extrapolate past performance, we are still not sure what the psychological roots of this are. Behavioral finance is still a young field, and thus far the research has focused mainly on understanding the psychological drivers of investing behavior, and specifically of investing mistakes. Going forward, there’s probably going to be a lot more research on how we can help people to overcome their psychological biases. But so far, there’s been relatively little of that type of work.”

With a title like head of behavioral finance and goals-based consulting at Merrill Lynch, it is perhaps unsurprising Michael Liersch is a little more upbeat about the field’s usefulness in practical financial advice.

Liersch says behavioral finance is one of the primary foundations of Merrill Lynch’s goals-based investing methodology for client servicing and portfolio management. The wirehouse’s Investment Personality Assessment tool is a proprietary psychometric and behavioral finance system for advisors to initiate conversations with clients about the intent of their wealth.

IPA slots into Wealth Outlook, Merrill’s longtime goals-based platform. Liersch says IPA helps advisors understand their clients as people and develop financial strategies aligned with their goals, risk tolerance, feelings and attitudes toward investing.

Drew McMorrow, president of Boston-based Ballentine Partners, which manages $5.9 billion, says it’s important that advisors are able to self-diagnose their own thoughts and actions before trying to apply behavioral finance principles to clients. His firm has a psychiatrist on retainer to help advisors better understand the psychology of investing.

“Advisors need to live it -- they can’t just read about these concepts,” says McMorrow. “Bad performance in a new investment is almost entirely due to emotional and psychological reasons, so advisors need to understand how emotions and psychology affects clients.”

But when it comes to how advisors themselves conceive risk, there’s a great deal of misunderstanding, thinks Paul Resnik, co-founder of risk profiling firm FinaMetrica.

“Many people seem to think that risk tolerance is a product of behaviour, which is why they often use different models for young investors, middle-aged investors and retiring investors,” says Resnik. “But nothing could be further from the truth. Risk tolerance is a personality trait that’s reasonably stable over time. Knowing an investor’s risk tolerance is an indicator of future behaviour.”

Risk tolerance, says Resnik, is a psychological construct. So it’s better assessed by a tool designed to make accurate assessments of personality –a psychometric test. This means advisors trying to ascribe risk profiles based on client behaviours will lead to incorrect conclusions and mismatched portfolios, says Resnik.

Paul Resnik

Jordan Waxman, managing partner of HSW Advisors, a New York-based HighTower team, thinks the correct usage of behavioral finance not only helps build a better service for clients, but also helps advisors stay compliant with the regulations that govern advice.

Under Finra rules, broker-dealers are responsible for assessing the suitability of an investment for a particular investor profile. Firms must be able to articulate how their advisor has appropriately calculated a portfolio’s risk, return and diversification, given the needs of the client.

“When you’re in a brokerage the only way to make money is to get paid by selling things. You can’t take the time and effort required to fully analyze and service a family’s life goals and investment needs,” says Waxman, questioning how suitable the end result can be for a client in such circumstances.

Liersch says even at brokerages the answer is the correct application of behavioral finance. “When assessing the suitability of an investment, choice of architecture is important. Advisors need to demonstrate they’re using a repeatable and modifiable system which identifies an investment as being right for the client. The process needs to be able to validate various levels of understanding, so that the advisor can have the right level of discussion with the client. The broker’s process needs to be predictive of the client’s goals and be able to connect investors with the appropriate strategy – and be able to revisit the decisions in a systematic way. This is the very definition of suitability and it’s exactly what correctly-applied behavioral finance does.”

And for RIAs, which are held to the stricter fiduciary standard, Liersch says “a key component of the rules is having investors’ best interests in mind.” Once again he points out “that’s what behavioral finance is about – knowing the client and acknowledging them in an authentic way.”

The SEC’s regulations require RIAs to be able to optimize financial outcomes based on a real person, not just fitting people into prepackaged portfolios, Liersch explains. Treating clients as real, emotional people requires advisors to have a good understanding of their clients. Liersch – and many other proponents – believe that you can do that a lot more easily by using behavioral finance correctly.