Almost 2 years ago I took the final portion of the CFA Exam. The materials for that section have completely changed the way I look at everything. Level I was focused on market fundamentals, Level II focused more on how to analyze the various asset classes available, while Level III focused heavily on portfolio management. The way I explain it to people, Level I was "this is how the market is supposed to work," Level II was "generally speaking this is how you would manage money if the market worked like it was supposed to," and Level III was "this is how to manage money in the real world because the market does not usually work like it is supposed to."
One of the primary reasons the market does not work like it is supposed to is because HUMANS are involved. Modern Portfolio Theory and traditional Economic Theory assume one thing -- all participants are 100% rational 100% of the time. As anybody that has been in the industry for more than a few weeks knows very few people fall into that category. There is nothing wrong with being irrational once in a while -- it's what makes us HUMANS.
The problem is when dealing with investing our behavioral biases come roaring to the surface at the exact wrong time. We might be able to oppress our biases under "normal" situations, but when we find ourselves under pressure, our natural reactions take over. When dealing with the markets that is often when stock prices are falling. As financial advisors it could also be when we are seeing clients leaving to pursue "higher returns". Whatever the situation, we need to do everything possible to remove those biases from the equation. The first step is identifying those biases.
Over the past year, SEM has rolled out tools to help identify each person's individual biases. We have been helping our our advisors how to then structure a portfolio to overcome those biases. We continue to work on new tools to assist in this critical part of the client relationship. As we build up to the full roll-out, I will continue to provide background articles on these behavioral biases so that it just becomes part of our natural decision making process whenever we work with a client and their investment portfolios. Last weekend, I read an interesting article on these biases. Included in that is something I think few of us in the industry are willing to admit -- our own personal biases influence what investments end up in our clients' accounts. I see this happening most often with the investment "platforms" that most Broker-Dealers are now pushing on their registered representatives.
The concept is sound -- have a platform full of a wide range of investment options that can be managed in one account. The problem is in the SELECTION of the options. Each investment style goes through cycles where it is in favor and out of favor. Without full understanding of how those styles work and how to use them in a portfolio, far too often I see portfolios overweight in just one or two styles. In addition, the numbers used to evaluate the different options often mask both the volatility & event specific correlations. With so many options at their disposal, I see far too many of these financial advisors letting their own behavioral biases take over when they become portfolio managers for their clients.
Back to the CFA Behavioral Insights article, the author summed up the problem in this way:
Finance professionals look toward the future, matching the future needs of savers with those of capital consumers. Capital investment requirements and financial markets are unpredictable, subject to abrupt and significant changes. Very few can forecast market requirements with accuracy and consistency or outperform the mean for an extended length of time.
This makes the job of wealth advisers exceptionally challenging. Not only must they understand the future needs of each client, they also must identify fund managers who generate investment returns in line with client expectations.
The vast and ever-growing pool of information compounds the problem even further. The data deluge adds to behavioral vulnerabilities, making everyone involved predictably irrational. As Dan Ariely strikingly said, “We were designed with a computation machine, a brain, to deal with jungles and different types of risks. And the machinery that we got did not have to be perfect, but it had to be very accurate. For example, if you see a tiger, you want to run away very, very quickly. You don’t want to stop and think about it. And if it’s not a real tiger, you still want to run away; why take the risk?” The fright and flight response when one sees a tiger is so deeply programmed that the casualty is misconstrued and the “rule of thumb” is often misapplied in investment decision making too.
Besides identifying the biases we personally experience on top of those of our clients, the best way to overcome any behavioral biases is with data. Without even knowing it, SEM has always applied a Behavioral Approach to Investing using Scientifically Engineered Models. 26 years ago when we were formed, there was no such thing as Behavioral Finance, but we knew from our own experiences very few people are 100% rational, 100% of the time, which means you need to do something to overcome this natural flaw. Our solution -- using DATA to make decisions, not our brains, which will use heuristics (mental short-cuts or rules of thumb) to process complicated decisions that are influenced by our emotions.
As we work on the roll-out of our new tools, please contact me if you have any questions on how you can structure your clients' portfolios to overcome their specific biases.
For more on our Portfolio Approach and how it blends with your work as a Financial Advisor, click here.