Wealth Strategies

The Growing Importance Of Behavioral Finance

Charles Paikert Family Wealth Report Editor New York 18 August 2010

The Growing Importance Of Behavioral Finance

A number of leading firms including Merrill Lynch, Northern Trust and JP Morgan Chase are in fact aggressively embracing behavioral finance in their day-to-day business, albeit in different ways.

The growing importance of behavioral finance in the aftermath of the financial crisis was dramatically underscored in the recently released and highly influential World Wealth Report by Merrill Lynch and Capgemini.

Noting that billions of dollars in assets are still in motion, the report states that wealth management firms are now “leveraging key tenets of behavioral finance to rebuild investor trust and confidence”.

A number of leading firms including Merrill Lynch, Northern Trust and JP Morgan Chase are in fact aggressively embracing behavioral finance in their day-to-day business, albeit in different ways.

The latest World Wealth Report devotes a special ten-page section to behavioral finance, stemming from the conclusion that one of the most profound consequences of the financial crisis has been the increasing prominence of “emotional factors” in the decision-making process of investors with $1 million or more in investable assets.

Developed in the 1970s and 1980s by academics including Amos Tversky, Daniel Kahneman, Richard Thayer and Meir Statman, behavioral finance stresses that psychology and emotion prompt investors to behave in ways that are inconsistent with what is considered rational in modern portfolio theory.

The field has now evolved to the point where “more mainstream uses of behavioral finance approaches will have a significant impact across service delivery models and platforms,” according to the report.

What’s more, the report concluded, wealth management firms can “differentiate themselves by integrating behavioral finance as they strengthen portfolio management and risk models and capabilities.”

So what exactly are some of the top firms doing?

Merrill: Understand biases

“We really want to help clients make better decisions,” said Steven Samuels, director of client solutions and global practice management for Merrill Lynch Wealth Management, “and if we understand biases and tendencies in making choices, it helps us be better counselors.”

Samuels notes that a white paper Merrill published in 2007, Beyond Markowitz: A comprehensive Wealth Allocation Framework for Individual Investors, covered some of the key concepts of behavioral finance, such as mental accounting, or an approach people use to organize their financial assets by creating separate compartments for money they’ve designated for specific purposes.

The three primary compartments, or “buckets” that resonate with high net worth investors, Samuels said, can also be seen as part of goals-based planning: personal risk (“do not jeopardize  my lifestyle”); market risk (“I want to maintain my lifestyle”) and aspirational risk (“I want to enhance my lifestyle”).

“We want to acknowledge that,” he said, “and when we do clients say ‘You get me,’ as opposed to having everything dumped into one pie chart.”

Top Merrill advisors have an opportunity to learn more about behavioral finance at courses offered to them at the Wharton School of Business in Philadelphia and the Stanford Graduate School of Business in Palo Alto.

The courses are followed up by an “action plan” with one, two and three month timetables, Samuels said, and additional information about behavioral finance is often available on Advisor Forum, Merrill’s monthly closed-circuit television show for advisors.

Northern: Paradigm shift

At Northern Trust, the increasing emphasis on behavioral finance is viewed as “nothing short of a paradigm shift in asset allocation,” according to John Skjervem, chief investment officer for the bank’s personal financial services division.

Behavioral finance “shows you deficiencies when modern portfolio theory is applied to real clients in the real world, providing a path to a better, more effective asset allocation framework,” Skjervem said.

As a result, he explained, Northern Trust is at “an inflection point” where it is “moving away from modern portfolio theory to a new era of goals-based planning.”

The concept of loss aversion, where investors perceive losses as disproportionately painful to gain, is a critical component of the shift, Skjervem said.

Instead of the symmetric relationship between return and risk found in modern portfolio theory, he explained, the “psychological overlay” of behavioral finance reveals an “asymmetric experience” of return and risk.

Once loss aversion is acknowledged, Skjervem said, models are used more judiciously. For example, the traditional risk tolerance questionnaire used by advisors is “not particularly useful,” he explained. “It’s too abstract and doesn’t do a good enough job of finding loss aversion.”

JP Morgan: Identify irrational behavior

JP Morgan Chase is applying behavioral finance when making investing decisions to its own funds, such as the Intrepid Value Fund.

“We try to identify irrational behavior and take the other side of the trade,” said Chris Blum, chief investment officer of the bank’s US behavioral finance group.

“Most of the irrational behavior comes from under-reaction or over-reaction to a stock,” Blum said.

In either case, if Blum and his team determine that the under-reaction or over-reaction is irrational, they will take the other side to capture the “valuation anomaly.”

An example of over-reaction, he said, is the plunging market value of companies associated with BP in the aftermath of the Deepwater Horizon oil spill in the Gulf of Mexico.

“The way to determine over-reaction is to see how cheap the stock get, and if it is identified as an over-reaction, then buy it,’ Blum said.

“It can be hard because you have to be able to embrace discomfort,” he said. “We’re human too, and sometimes it doesn’t feel good at all.”

No matter how behavioral-driven investing is applied, the World Wealth Report concluded that it is here to stay.

“We believe [it] represents a major global socio-economic trend that will create significant opportunities for industry growth and transformation,” the report stated.

But it also warned that firms who incorporate behavioral finance more deeply into different processes and organizational models “will need to do so in a standardized, scalable and efficient way or the approach won’t be sustainable or profitable.”

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