Greg B. Davies of Barclays Wealth explains the practical role that behavioural finance plays in wealth management, in particular to identify different personalities.
Date: Dec 2010
Standard economic theory makes heroic assumptions that people are always rational, he explained, while behavioural finance tries to soften these assumptions and recognise that people can act irrationally.
This therefore means asking questions about how people make financial decisions rather than assuming people are always rational, said Davies. And in doing so, behavioural finance can create a more realistic model of how markets operate, in turn leading to advice which is more pertinent to real human beings.
Behavioural finance in wealth management
As a result, Davies said there is a big role for behavioural finance within wealth management.
When talking about individual clients, for instance, it is obvious that people’s comfort with their portfolio and their financial decision-making – as well as the way an individual’s financial performance integrates with all other aspects of their life – are all behavioural, he explained, and not rational in an economic sense.
As a result, if advisers are trying to create a portfolio for a client to provide the best possible outcome for them as individuals, Davies said it is essential to understand who they are and how they approach decisions. Plus it is also important to focus on what is going to make them happier with their portfolio, and therefore better able to make good decisions along the journey.
Yet traditional finance tends to ignore the overall journey, he said, and instead says that the end-goal of good returns relative to the risk taken is the critical thing. While this is certainly a desired outcome, Davies said that good decision-making along the way contributes to returns. This in turn relies on people being comfortable with their portfolios.
So by recognising the human element and the fact that people have emotional responses to situations, Davies said advisers can help make individual clients comfortable with their portfolios, and therefore improve their decision-making and reduce their tendencies to do things such as get overly-fearful at the bottom of the market and pull out, or get over-excited at the top of the market and double up on risk.
Such actions will cost a client a lot in terms of performance, he explained, so if someone is emotionally comfortable with their portfolio they will be happier and, ideally, wealthier.
Different investor personalities
According to Davies, there are six dimensions of personality. The first, and most standard, he said, is risk tolerance, which is also the only one to which classical finance pays any attention.
Risk tolerance relates to – in the long run – when someone is thinking rationally about their total wealth, how much risk they are prepared to take on, and therefore what returns they can expect. This is fundamentally important in wealth management, he said, and the cornerstone of building the right portfolio for any client. However, in a situation where two clients have the same risk tolerance but are completely different from each other in all other aspects, Davies said there should be a different portfolio for each client.
The other two dimensions of someone’s personality which relate to risk attitudes are: composure and market engagement.
Composure is the degree of an individual’s emotional involvement with their own decisions in the short term, explained Davies.
Two individuals with the same risk tolerance but different composure scores therefore need different portfolios. For example, he said, someone with high composure is likely to not rebalance often enough. By contrast, someone with low composure is going to be susceptible to making too many emotionally-driven decisions – so at best they will transact too frequently and incur excessive transaction costs, and at worst they will fall into the trap of buying high and selling low.
Market engagement, meanwhile, measures the degree to which someone is happy to get into a market all at once or gradually, said Davies. For example, often with entrepreneurial clients – who are high risk-takers by any standard measure – when they take money out of their entrepreneurial activities to put into the financial markets, they are suddenly very aware of the risks.
This isn’t because they are not risk tolerant, he explained, rather they are entering a domain where they don’t feel in control of the risks and they might not fully understand them. As a result of this dimension, Davies said people typically sit on the sidelines and risk not getting the level of returns which they might be able to.
Barclays Wealth, therefore, changes a client’s portfolio in certain ways to make it more comfortable for these people to get into the markets gradually, said Davies. This might involve recommending, for example, dollar-cost averaging over time, and also paying for some downside-protection so investors no longer fear the worst case scenario.
The other three dimensions to measures an individual’s personality are related to an individual’s financial decision-making style, said Davies. These are simpler to access because they are more familiar concepts for people to understand.
First is a person’s desire for delegation, and whether they want to invest themselves and stay in control, or whether they are happy to let others invest on their behalf and so pass control to an adviser.
Secondly is an individual’s perceived financial expertise, and whether they feel confident in their own decision making.
Thirdly is someone’s belief in skill – and whether they are the sort of individual who believes it is worth paying a premium for an active manager to try to beat the market.
According to Davies, each of these three dimensions will lead Barclays Wealth to change the product mix in specific ways to make sure an individual’s portfolio is truly adapted to what makes them comfortable –despite potentially having the same high-level asset allocation as another client, and the same long-term, risk-return trade-off.
So where a client is paying a premium, he explained, they will be doing so because they are psychologically pre-disposed to thinking that this premium is worth paying.
Predicting investor reactions
When trying to predict how an investor might react in certain situations, Davies said it is important to look at stable psychological pre-dispositions to act in a certain way.
This means looking for fairly high levels of objective insight into individuals which can be used to inform a discussion.
It is not about predicting client’s responses, he explained – rather understanding who they are and using that to help them respond better in certain environments by taking practical steps to adapt their portfolio accordingly.
So while some people are more inclined to focus on the short-term, when something like the financial crisis happens, even those people who are typically quite relaxed about short-term volatility start to get stressed, said Davies. There are always circumstances where an individual’s personality and natural pre-dispositions will change, he added.
Avoiding behaviour-led mistakes
Mechanically, Davies said there are simple steps for investors to take to avoid making behaviour-led mistakes. For instance, ascertaining a long term, sensible, strategic asset allocation – and then constantly rebalancing the portfolio.
Psychologically, however, this is difficult to do, he explained, as can be seen not just an individual level but also at both a corporate and government level – when things are going well, people spend and invest more, and worry less about risk management.
This isn’t necessarily universally wrong, given that the direct opposite – the fear of getting into a market – can lead to people sitting on the sidelines and missing out on the upside, said Davies.
However, while anticipated regret of failure is the general dominating factor and normally leads to people sitting on the sidelines for too long, anticipated fear of losing out is often the cause of the biggest losses in any form of investing. So finding a balance between these two fears is essential.
