Head games: Helping quell investors' irrational antics

by Cynthia Harrington

Proponents of “behavioral finance” gained credibility during the recent boom-and-bust cycle. Investors can become irrational and their irrational behavior affects their ability to profit from owning stocks and bonds, say behaviorists. Some advisors have learned to work with clients’ natural tendencies and are making their lives easier as a result.

“I use the behavioral research to coach clients,” said Mark Balasa, CPA, CFP, of Balasa Dinverno Foltz & Hoffman, in Schaumburg, Ill. “When clients are overconfident, when they’re anchoring or practicing mental accounting, I mirror back to them what they’re doing to show how they’re getting in their own way.”

Overconfidence leads to unreasonable risks, anchoring means that clients hang on to the past even in the face of new information, and mental accounting means investors take shortcuts to conclusions without considering all the possibilities. All form the basis of behavioral finance, which argues against the prevailing belief that investors are rational and respond quickly and accurately to new information.

The new theory was popularized by Robert Shiller in his bestseller, “Irrational Exuberance.” Academic research in this area flourished after the 2002 Nobel Prize in Economics was awarded jointly to psychologist Daniel Kahneman and economist Vernon L. Smith. 

Much is yet to be done in order to make the theory especially useful to advisors. “These concepts are helpful in knowing how to treat people,” said Balasa. “But, right now, it’s hard to apply because there are no models to use to invest client assets once we go through the theory.”

Advisors who understand the irrationality of clients report success in dealing with the bear market. Mitch Freedman, CPA/PFS, of MFAC Financial Advisors, in Sherman Oaks, Calif., said that he hasn’t lost one client during the current protracted decline in the market. He credits this success to his astute understanding of client psychology and his ability to manage that and apply an investment discipline.

“I carefully qualify the people I’ll work with. If their expectations are unrealistic to begin with, they’re not a good fit for me,” said Freedman. “Then I become their mentor, their teacher, their manager. I’m their conscience that allows them to make good decisions.”

Rational investment discipline depends on a client having a well-diversified portfolio and regular rebalancing. The financial planning process counteracts overconfidence, anchoring and mental accounting by making the plan to meet goals, and then sticking to the plan.  The trick is getting the client to stick to the plan as market conditions change.

Freedman guides clients with certain mantras. He tells clients he doesn’t want them to thank him when their portfolio goes up, because he didn’t have anything to do with it. Of course, the reverse holds true as well. He teaches clients that money is not a goal, it’s a tool to help achieve goals. “There’s no way to structure a portfolio if a client doesn’t have goals,” he said.

Behavioral portfolio management focuses heavily on the fact that investors
practice mental accounting, putting different goals into virtual separate accounts. Investing for one’s own retirement carries a different risk tolerance than trying to leave one’s heirs a nice chunk of change.

“I give clients the example of their investment plan as being like a man wearing a pair of pants,” said Freedman. “Different goals are like different pockets. College savings might be in the left pocket, retirement in the back pocket, and gifting to charity might be in the shirt pocket. Then we manage to those goals.”

Here is where the theory breaks down.

While behavioral finance explains how investors view their portfolios, it doesn’t provide any models with which to invest assets based on the knowledge. “Behaviorists help to discuss investment situations with clients,” said Benjamin Tobias, CFP, CPA, CIMA, of Tobias Financial Advisors, in Ft. Lauderdale, Fla. “But I don’t subscribe to it as far as asset allocation goes.”

Tobias does use one of the two mutual funds that employs behavioral finance techniques in stock selection. He started working with Undiscovered Managers’ Behavioral Finance Growth Fund because he inherently understood the thesis.  “They showed how the point of view of two analysts colored their conclusions about a stock,” said Tobias. “The analyst from New York City had a different meaning when he described something as big, from the analyst from Nebraska.”

Fund subadvisor Fuller & Thaler Asset Management Inc. employs behavioral science founder Richard Thaler. The goal is to “identify mispriced securities that result from the behavioral biases of key market participants.” Since its inception in 1997, Behavioral Finance Growth has averaged 1.47 percent annually, versus -3.43 percent for the Russell 2500 Growth Index.

A value fund was added in 1998. Behavioral Finance Value is up 7.63 percent a year, versus 4.39 percent for the Russell 2000 Value Index. “These people really made sense when we went through the tech bubble,” reports Tobias. “I couldn’t believe the numbers in the late 1990s and looking at investor behavior helped to explain what was going on.”

While the theory makes sense, even Tobias questions whether behavioral finance will ever be able to quantify models that lead to long-term investment success. “These funds did much better than the market on the upside, but now they’re not doing much better than anyone else,” said Tobias.

For now, the help in managing client expectations is appreciated. Tobias, for instance, is now cutting exposure to real estate investment trusts. The class has outperformed expectations and he’s reallocating assets to less popular classes. But clients wonder about getting out of what has been doing well.

They’re anchoring, or expecting things to continue as they have been. “Most people think if things are going well they’ll continue to go well, and if they’re going poorly they’ll continue to do poorly,” said Tobias. “This is a dangerous outlook because they tend to want to stay in an area too long.”

Advisors still need better tools to apply the tenets of behavioral finance. They need ways to quantify the affect of irrational behavior to explain what goes on in markets in the quest to beat indexes. They need methods to structure portfolios to match how clients view different savings goals with different levels of risk.

In the meantime, advisors who know how to recognize irrational behavior and coach clients around it report greater client satisfaction. “When the client knows their goals are being met, it helps them stay with the program,” said Balasa.

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