Here, the head of Barclays Wealth's behavioral finance division discusses how emotionally-driven decisions can impact investment returns, and how using basic rules to develop habits can improve financial discipline.
Despite their considerable success in amassing wealth, 41 per cent of high net worth individuals around the world believe they tend to act irrationally when it comes to their financial behaviour, the latest survey from the Barclays Wealth Insights series revealed. Due to this, the UK-listed bank takes this discipline seriously, and has invested considerable resources in developing a behavioural finance unit.
Barclays Wealth has had a behavioral finance team since 2006, and Greg Davies, who heads up the division and holds a PhD in behavioral decision theory from Cambridge, says the firm doesn’t subscribe to the popular perception of behavioral finance as a competing ideology to classical theory (of rationality), but rather as a way of taking us closer to the classical frontier. “Classical finance may be the right answer, but how do you get there?” he tells Family Wealth Report in an interview.
The emotional investor
“No matter how good your portfolio is, people give away a lot of upside,” says Davies.
Essentially, investors aren’t emotionless robots, and any strategy that assumes they are will have a cost.
Exogenous, unpredictable shocks often hit markets, and selling at the wrong time happens to most investors at some point, as they aren’t blessed with perfect knowledge. But how much of the upside lost is due to these unknown factors and how much is lost due to bad decisions driven by our emotions? And can you separate the factors and quantify the cost of avoidable error?
“We can start to put number on it, this is being done,” says Davies, citing a Cass Business School study. This found that a typical balanced portfolio could forsake 1.2 per cent per year, and that consequently you might be giving away 20 per cent over a 10-year period, taking into account effects of compounding.
“And it’s not because you don’t have the right answer, it’s because you don’t implement the right answer,” he says. “It sounds obvious to buy low and sell high, but our psychology tells us to do the opposite.”
The private bank’s Financial Personal Assessment tests six facets of an individual’s behavior as an investor, including composure, risk tolerance and market engagement. In terms of market composure, at one end of the scale is an investor who makes panic decisions and at the other end is an investor who is too laid back and does not re-balance frequently enough, explains Davies.
Market engagement relates to a lack of familiarity with the financial world. For example, a successful entrepreneur who is a big risk-taker in his or her business life but is unfamiliar with financial markets might take too little risk because of a familiarity bias – the same phenomenon that sees investors favoring their domestic markets.
However, knowing clients have these traits is not enough in itself. How do you persuade people to change embedded habits? One thing you can do, says Davies, is make targeted changes to a portfolio, creating buffers against situations which will trigger a negative reaction in the owner. So for someone with low composure you target how the portfolio will react in market stress and explain the consequences to the investor, hopefully making them feel more secure when markets fall.
There’s no free lunch though, Davies points out, and by creating these buffers you might sacrifice some return, so it’s not appropriate for everyone and you have to look at it from a cost-benefit perspective.
Another issue is that in times of extreme market volatility, as in 2008, all assets correlated to one – the buffers fail when they are most needed. But Davies says there are small changes you can make to improve on this. First of all, if clients understand there is some protection built in to their portfolio, they will not feel so threatened and have a knee-jerk reaction. This helps mitigate the “action bias,” where investors feel compelled to “do something” just to reinstate control.
Furthermore, as habits often guide our behavior more than self-discipline and academic knowledge, simply having clients develop basic rules and strategies in the way they invest can be very powerful over time, as these strategies become entrenched. An example of a strategy might be always speaking with a certain trusted advisor before making a change affecting over 5 per cent of your portfolio.
“You just need a sensible set of rules,” says Davies.
Other banks are starting to take notice of this growing field. Allianz Global Investors has founded a unit, and Davies hopes that for investors’ sakes this will not be a “buzz topic” or a fad.
“A lot of people are talking about it, and that’s the worry – it’s very easy to talk about, but not at all easy to do well. We’re putting a lot of investment into this, and if people talk about it without doing anything it runs the risk of discrediting [the discipline],” he explains.
However, he is optimistic it will continue to gain traction: “As a team we started working together well before the crisis, and we’re still here and much bigger.”
“We are far enough out of the crisis now that banks are no longer just cost cutting, and hopefully they will take this seriously.”