Oh, Do Behave! Forget derivatives and market crashes: the biggest obstacle to HNWs investing well is… their brain. Thats where behavioural finance comes in, says Freddy Barker
Oh, Do Behave!
Forget derivatives and market crashes: the biggest obstacle to HNWs investing well is… their brain. That’s where behavioural finance comes in, says Freddy Barker
IT’S JULY 1961. Over the course of a few days, a group of men in Connecticut are presented with electric switches marked with descriptions of pain from ‘slight’ to ‘severe’ to ‘XXX’. They’re told to electrocute learners in the adjoining room at the behest of the teachers beside them. Some 80 per cent do so — until they hear agonised screams; 62 per cent persist — until a deadly silence prevails.
Fake teachers, learners and electric jolts aside, the results of Stanley Milgram’s Yale experiment show that most humans will do anything if told to by an expert — food for thought the next time your wealth manager pushes a product or a strategy, and one of many startling conclusions applicable to behavioural finance, a discipline that proves having money doesn’t necessarily mean you know what to do with it.
Despite its merit, behavioural finance has taken a long time to catch on. It shot to fame in the Noughties after Daniel Kahneman won the Nobel Prize for better explaining the behaviour behind market crashes; after Malcolm Gladwell’s Blink hit the bestseller list for popularising the power of intuition; and later after David Cameron founded the Nudge Unit in Downing Street to inspire social cohesion.
Yet advocates are still few and far between in private banking. Barclays, Britain’s biggest wealth manager, has at least charged Cambridge PhD Greg Davies with overhauling the asset allocation process and straightening out the investment committee’s kinks.
‘When I arrived,’ Davies says, ‘I found a considerable amount of intellectual interest in behavioural finance but a great deal of scepticism about its practical usefulness. So instead of writing newsletters and delivering presentations, I set about building and implementing a practical tool to make it come alive in the hands of our bankers.
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‘The Financial Personality Assessment measures six dimensions of how investors respond to the investment journey, including long-term risk tolerance and short-term composure in the face of market turmoil. Its effect has been to make behavioural aspects central to advising clients and allow the language of personality to permeate the culture of the firm.’
Davies’s breakthroughs are relevant whether or not you bank with the Canary Wharf behemoth. Given they have increased satisfaction and asset levels, they may well start to reverberate through the industry and encourage HNWs to think about whether they’re profiting from their proclivities.
There are three places to start. First, behavioural finance posits that the wealthy are bad at picking advisers as their natural inclination is to select like-minded folk, rather than intellectual sparring partners.
Stanford psychologists Mark Lepper, Charles Lord and Lee Ross illustrated the danger when asking capital punishment students to rate randomly selected studies: alarmingly, all those who were ‘pro’ before thought the articles that supported the death sentence well argued and all those who were ‘anti’ thought the opposite. The experiment proved that given balanced advice, humans simply reinforce their own beliefs — a costly stance if you were bullish on equities in 2008.
Second, behavioural finance suggests that even if HNWs pick the perfect adviser, they are unlikely to be given the perfect products. Rather than providing bespoke advice, many bankers simply recommend variations on their own ideal portfolios as they are most convincing when advising on things they’d be comfortable owning or in which they have expertise.
HNWs fall for this because they are inclined to believe narratives. Ellen Langer proved so at Harvard when she performed an experiment involving queue jumping at the photocopier: when provided with a rubbish excuse (‘I need to make copies’) 60 per cent allowed it, but without one 42 per cent did — showing that a good yarn about a Euro-recovery would have convinced many a millionaire in 2012.
The third thing that HNWs might be surprised to learn from behavioural finance is that even if they are lucky enough to pick the perfect adviser and the perfect portfolio, their own behaviour is likely to dilute the effect. Humans’ emotional inability to handle short-term market collapses is at odds with the long-term plan that maximises investment returns, so average HNWs lose as much as 3 per cent per annum from portfolio adjustments, according to Barclays. Add inflation and fees on top and a 6 per cent return is required to maintain purchasing power — an expensive way to sleep at night.
AT THIS POINT, it’s looking worrying on the advisory front, so one can understand the post-2008 trend towards investing one’s own money. Why not, too, given the blow that wealth management was dealt by the credit crunch? This was a time when cash funds couldn’t protect, Ponzi schemes by Madoff and Stanford were unravelled and seemingly safe structured products exposed Lehman as counterparty.
So when it comes to personal investing, what secrets do behavioural scientists hold? James Montier at GMO believes — ironically — that optimism is the main concern. He found, when at Société Générale, that 75 per cent of fund managers think they are above average at their jobs. And it’s not just the financiers: when a group of doctors diagnosed patients, they thought they were correct 90 per cent of the time: in fact, it was 15 per cent.
The danger lies in the way these unrealistic expectations affect forecasts. For example, Montier’s paper Seven Sins of Fund Management cites a study in which judges were asked to roll dice before determining sentencing requests. The dice were loaded to give either a three or a nine and as the judges rolled them, they could see the input was totally irrelevant.
However, those who rolled low scores issued average sentences of 5.3 months, while those who rolled high scores issued average sentences of 7.8 months, proving that humans are subconsciously drawn to forecasts, no matter how bogus.
The risk of these egregious estimates contaminating investment results is compounded when it comes to HNWs. Past financial successes can lead to hubris — fair enough, considering the nature of entrepreneurship is taking a position outside the public imagination and standing firm until the rest of the world sees your vision — but overconfidence can lead the wealthy to stick to bad investments no matter how far they fall.
Take Julian Robertson, the Tiger Management hedge-funder, who clung to US Airways stock through the blocked United Airlines takeover until it crashed his $20 billion fund. That was irrational optimism in the extreme.
ON A BROADER level, Robertson’s plight exemplifies why behavioural finance is more than the traditional banking slur of ‘parlour games’ suggests. As Greg Davies says, ‘We should understand biases not as irrational, but as behaviour that serves the needs of our short-term emotional brains, our craving for immediate emotional comfort in a risky world.’
In the future, the discipline can be harnessed through frameworks. Critics argue that the cross-cultural assumptions therein are a bridge too far, as ten years ago UHNWs were focused in a handful of developed countries whereas today they come from the four corners of the earth.
But banks have to find a balance between the investment solutions which make the wealthy rich in the long term and those that provide emotional comfort in the short run. Happily, if they adapt to client biases at UHNW levels while encouraging clients to modify their own behaviour at HNW levels, then it is both possible and profitable as higher satisfaction levels mean a greater share of wallet.
If it is implemented, the wealthy should see the payoff in good behaviour, too. The spectre of arbitraging others’ emotional inefficiencies to one’s own financial gain looms — or would that be irrational overconfidence again?
Illustration by Phil Wrigglesworth
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