Greg B. Davies of Barclays Wealth looks at the main biases among investors within wealth management, and explains how relationship managers can try to address these effectively.
Date: Dec 2010
Tags: Behavioural finance, Bias, Irrational, Loss aversion
The first main bias is narrow framing. This means that people have a strong tendency to divide their wealth into small pots and make decisions on these individually, he explained, or to treat each transaction in isolation without consideration to the effect on the risk and return of their overall wealth.
Given that such stand-alone decision-making fails to take into account the benefits of diversification, people will likely decline certain trades which will actually be beneficial for their portfolio, said Davies.
The second main bias is myopic loss aversion. Loss aversion means people have a strong tendency to be more emotionally affected by losses rather than gains, he explained. In fact, the pain of losing $100 is about twice as strong a feeling as the pleasure from gaining $100 – which can therefore lead people to make some irrational decisions.
For example, said Davies, many people tend to see the world in a short-term way and focus on their potential returns over a few months – rather than looking at growing their wealth over the course of their life and even beyond.
In line with this, if someone looks at, for example, the S&P 500, they would see that the proportion of losses over a 1-month period is about 40%, compared with the chance of loss over a 5-year time horizon being around 10%.
Because people are loss averse, simply by re-framing the same investment decision and focusing on performance over a 5-year rather than 1-month time horizon, Davies said people can end up making a different decision.
People therefore need to align their investment decisions with their genuine investment timeframes, which are typically long term, he advised.
Another consequence of myopic loss aversion, said Davies, is that people under-invest and sit on the sidelines with far too much of their wealth because they worry about what might happen in the short term. Yet they don’t ask themselves whether a particular moment in time is a good entry point for a 5- or 10-year investment horizon.
The third main bias, he explained, is a natural inclination to invest when comfortable and disinvest when uncomfortable – leading to sub-optimal behaviour.
For example, as the market rises from its bottom, people move from being fearful to gradually getting more hopeful and optimistic, but they have generally only put a little bit of money into the market, and therefore not made the most of the lower levels. Then, as the market rises further and people get more comfortable and invest more, they start to have anticipated regret of missing out as they haven’t made as much of a gain as others who invested earlier.
Davies said that most investors therefore put more money in at the top rather than at the bottom of a market, so get poorer returns than they should be getting.
As an example, a recent study on UK equity investments over a 20-year period compared the difference between the average return of a buy-and-hold strategy versus the return of the average pound sterling invested.
The results showed that the average investor, through their own decision-making on trying to time the market, was throwing away 120 basis points per year in performance – not even accounting for transaction costs.
Discussing behaviours with clients
According to Davies, when RMs discuss such biases with their clients, it is vital that they get their communication right.
This is where the behavioural finance field has gone wrong in recent years, he explained, with a lot of the writing about it focusing on negative biases and the inability of individuals to make good decisions.
However, while biases do come into play, the fact is that a lot of people make good decisions effectively in a lot of aspects of their lives, he said.
At Barclays Wealth, Davies said there is an objective investigation into an individual’s financial personality. This helps to show clients where they are pre-disposed to responding in certain ways.
It is about helping an individual realise the specific circumstances where their natural psychology is likely to help them, and where it is likely to hinder them, he explained.
Then it is possible to build a portfolio along with a decision-making strategy for clients to overcome the biases when they arise.
For example, said Davies, while some people think low composure is a bad thing, that isn’t always the case. A lot of Barclays Wealth’s entrepreneurial clients are high risk-tolerance but low composure – which is because they need to be emotionally engaged with the short term to be able to make quick but good decisions in running a business.
When someone with low composure is, however, trying to make quick decisions where they are not an expert and might not be as comfortable, this is where poor decision-making such as buy high-sell low occurs, said Davies.
