If going really wild -- so out there that you wouldn’t tell your friends -- means moving from a three-month Treasury bill to a one-year certificate of deposit, you’re probably suffering from Irrational Prudence Syndrome, a non-medical but widespread condition that results from overexposure to volatile markets. IPS is characterized by extreme aversion to equities and uncontrollable urges to stuff cash into government-guaranteed mattresses, be it a CD, a Treasury security or even a checking account. Left untreated, IPS can lead to poorer investors -- and frustrated advisers. It’s a syndrome financial firms dread, and one they are determined to cure.
That may mean probing a client’s “financial personality.” Or it may involve creating “goals-based” investment buckets, with the riskiness of each pot of money customized to how crucial the goal is -- a child’s college, a vacation, retirement -- and how far off it is. Another technique to get clients to increase their investments is a form of shock therapy: Running a current photo of a client through age-progression software to show how he’d look at retirement -- gray hair, drooping jowls and all.
After having seen their portfolios age poorly in recent years, investors are skeptical of performance claims. Thus, in financial marketing, “There’s always a shift away from pushing performance when there’s a downturn in the market,” says Mercer Bullard, an associate professor of law at the University of Mississippi and founder of investor advocacy group Fund Democracy. As well, “[firms] are trying to push people back into equities from cash.” That, of course, would be profitable for the firms. Bullard doesn’t view it quite that cynically: “Another reason [they’re doing this] is that they’re trying to make sure people have the right level of equities so they don’t lose their shirts to the declining value of money over time,” he says.
Companies including Bank of America Merrill Lynch (BAC), Barclays Wealth (BCS), JPMorgan Chase (JPM), and Allianz Global Investors (AZSEY) are increasingly using behavioral finance -- the study of how unconscious biases influence financial decisions -- to strengthen their relationship with clients and figure out what products to offer them. According to behavioral finance, our emotions lead us to make portfolio-sapping moves like buying high, selling low and holding on to declining stocks rather than cutting our losses. And now, via the Internet, we can implement all the hasty decisions we want with ease and at low cost, with no buffer between us and our money to prevent these harmful transactions. Financial firms say investors need to better understand their true risk tolerance -- and they need a portfolio that they can live with through market gyrations.
The shift toward more therapeutic financial help from advisers is also showing up in the exam people take to get the Chartered Financial Analyst designation. The CFA Institute’s 2012 curriculum includes beefy sections on behavioral finance and more emphasis on long-term goals and building the psychological strength not to panic on market drops. Armed with that training, a CFA adviser might well quiz clients on how they’d react to hypothetical scenarios, or ask them to keep an “investment diary” tracking reasons for their investment decisions. If their financial willpower weakens, clients can refer back to their rationale, which may calm them or just show “the limitations of our ability to make good financial predictions,” says Stephen Horan, head of private wealth at the institute.
Barclays Wealth has made a big push into behavioral finance. The firm wants the science “deeply embedded” in the way it does business with wealthy clients, says Greg Davies, head of behavioral and quantitative finance at the firm. “It needs to be drip-fed into every client meeting.”
After unrolling a behavioral finance effort in the U.K., Barclays turned its attention to training staff in its 14 U.S. offices last year. Its main tool is a “financial personality assessment” -- a series of 36 statements that clients respond to by checking one of five answers ranging from “strongly agree” to “strongly disagree.” Examples are “I fear for the worst,” “I get stressed easily” and “I have invested a large sum in a risky investment for the excitement of seeing whether it goes up or down in value.”
Davies says using behavioral finance helps clients get better returns over the long run. Success is “difficult to measure,” he adds, because sometimes clients are deliberately steered toward lower-performing, less risky assets so that they’re more emotionally comfortable with their portfolio and less prone to making bad decisions.
Literally putting a face on savings is one way some firms will try to get clients to save. Allianz Global Investors’ Center for Behavioral Finance, launched in June 2010, will provide advisers with tools like age-progression software to use with clients. It shows how someone would physically look at retirement age. “If they can connect to themselves in the future, they will save more money,” says Cathy Smith, co-director of the center.
Firms are also trying to better connect with investors through products that mimic their natural “mental accounting.” Most people divide money into “mental buckets” earmarked for something -- travel or a grandchild’s education, for example -- and academic studies have shown that simply attaching a specific goal -- or face -- to a bucket of money can greatly increase how much a person saves.
Bank of America Merrill Lynch is building such goal-specific portfolios for its ultra high-net-worth clients. The portfolios in its new “goals-based wealth management” program will take risks commensurate with the importance of the goal. For example, “must-have” or essential goals are funded with portfolios that take less risk than portfolios meant for discretionary goals, says Anil Suri, head of investment analytics for Bank of America Merrill Lynch.
In a sign of the buzz around behavioral finance, while money poured out of most equity funds in August, some funds that use a behavioral approach gained assets. JPMorgan Chase’s Intrepid Funds, which use behavioral finance principles to pick stocks, saw assets under management rise from $5.8 billion at the end of 2008 to $11 billion as of May 31. That growth was 38 percent faster than for all equity funds, according to the Investment Company Institute. From Aug. 1 to Aug. 19, the Intrepid Funds had net inflows of $28 million.
Battling Your Emotions
Christopher Blum, chief investment officer of the U.S. behavioral finance group for J.P. Morgan Asset Management, says the panics and volatility in recent years have given more credence to the fact that markets may be driven by emotion. It’s shown that investors who act on opportunities (such as buying on dips) and stick to their investing rules “even if it doesn’t feel right” can prosper, he says. For an interactive look at how investors tend to pour money into markets as they rise, pull it out when markets fall and do best when they follow a steady course of regular investing, see the interactive graphic “Investors’ Emotional Roller Coaster.”
Financial firms are also doing more to root out the behavioral biases of their employees. Cabot Research uses software based on concepts developed by University of California at Berkeley professor Terrance Odean to analyze every decision made by managers. Relying on heavy computing power -- it takes 100 computers three days to evaluate one portfolio -- Cabot identifies common mistakes, such as holding on to stocks for too long, and tracks portfolios to make sure the mistakes aren’t made again. Chief Executive Officer Michael Ervolini says business is booming. The firm tracks 49 portfolios holding $600 billion in total, up from 13 portfolios two years ago.
Cabot client Joel Fortney, a research analyst who specializes in behavioral finance at Principal Global Investors, the $239 billion asset manager, says an emphasis on behavioral finance is improving the firm’s investing. It also sparks the interest of potential clients, Fortney says. “It’s a measure of your skill as an investor,” he says. “If you aren’t aware of these topics, you’re probably a victim of them.”