From the May 2006 issue of Investment Advisor • Subscribe!

May 1, 2006

Profiting by Behavior

Wealth managers understand what's going on in their clients' heads

Competition for affluent clients is fiercer than ever. To attract their attention, you need to stand out from the crowd. You must have better insights about your clients and the markets and a better process to deliver your services. In other words, you have to be a wealth manager. The foundation for any wealth management practice should start with a solid understanding of your clients' behaviors. Research conducted by JPMorgan and outside sources confirms that clients today demand more from their advisors. They want strong and substantive personal relationships with their advisors, and want them to understand and care about their personal goals and preferences.

Each month in this space we will share the findings of our proprietary research and offer our insights to help you gain greater knowledge of the affluent. That knowledge will help you to provide wealth management services to your clients in the most efficient manner.

To begin, let's discuss the drivers of investor behavior. We might like to think that investors act rationally, without letting emotions dictate their investment decisions. We might believe that investors always act in their own economic self interest, and that they always seek to maximize their returns for a given level of risk.

Unfortunately, that just isn't so. In the actual world of investing, reason and logic rarely dictate investment decisions. If behavior were always rational, investors would never sell stocks in a panic at the first sign of trouble. If dispassionate homework were always done before investing, stocks would never be bought due to hunches, hot tips, or media hype.

As Benjamin Graham once said, "The investor's chief problem--and even his worst enemy--is likely to be himself."

Why do we so often get in the way of our own success? The short answer is that it's all in our heads.

You see, the brain is not wired to always make rational decisions. It has three separate, distinct segments that control different functions. One controls autonomic functions, another the emotions, and the third controls logic and higher-level thinking.

Psychologists have looked at situations in which the response dictated by the "emotional" segment of the brain is at odds with the response dictated by the "logical" segment. When this happens, the researchers found that the "emotional" wins out, perhaps indicating why individuals exhibit so many irrational behaviors in everyday life and when investing.

In everyday life take, for example, such irrational behaviors as a person who:

  • purchases a burglar alarm the day after someone breaks into his house;
  • believes he is getting a bargain because the salesperson started negotiating at a price well above the market value of the product;
  • believes he is better than other people. In the individual investor's life, take the person who in evaluating an investment:
  • places too much emphasis on recent events;
  • assumes an investment's current price is about right, despite the absence of any plausible information supporting the assumption;
  • believes resolutely that he can beat the market, despite all the evidence showing that investors cannot do so on any systematic basis.

These three behavior biases are commonly known as recency effect, anchoring, and overconfidence.

We will explore how portfolio managers, when focused on behavioral finance, seek to capture opportunities in the market created by irrational investor behaviors. Then we will review how advisors focused on behavioral finance can capture market share opportunities created by these irrational investor behaviors.

Market Opportunities

Behavioralists believe that irrational investors create market anomalies (where stocks are mispriced due to incomplete or irrelevant information) that if taken advantage of can uncover opportunities for increased alpha.

More importantly, they believe the same anomalies will continue to occur in the future because humans are prone to repeat their mistakes. In other words, we tend to behave irrationally in predictable and systematic ways, creating ongoing opportunities to profit from other people's mistakes.

The market anomaly for the recency effect is momentum. Over the short term, behavioral finance theorists believe that stocks will continue to move in the same direction they have been heading. For example, stocks that have been rising continue to rise because investors assess a company's future prospects based on its recent results. Just look at the Nasdaq's meteoric rise from 1,000 to almost 5,000 in little more than four years. During this time, many investors jumped on the trendy new technology bandwagon because prices were rising and nobody wanted to miss out on the ride (see chart above).

Traditional finance theory was hard pressed to explain this rally because the fundamentals and earnings of most dot-com companies didn't support such high stock prices. Clearly, investor emotions and biases were also at work. At the time, Fed Chairman Alan Greenspan called it "irrational exuberance." Behavioral finance theorists called it "momentum."

The investment strategy for momentum is to buy stocks with positive momentum (because history suggests those stocks will continue rising), and to sell stocks when price momentum turns negative. This strategy is designed to ride the upward momentum of investor optimism while limiting downside risk by selling when that momentum shifts.

The market anomaly for anchoring is analyst earnings revisions. Stocks with upgraded earning expectations are more likely to improve further because history suggests that all the good news has not yet been reflected in analysts' forecasts. History shows that analysts tend to selectively filter new information in ways that support their initial estimates because they're anchored to their original assessments. It can take several revisions before all the relevant news is reflected in their reports, so estimates tend to lag actual earnings rather than anticipate them (see chart below).

The investment strategy for analyst earnings revisions is to recognize opportunities early. Buy stocks when there are positive revisions, because all the good news is not yet reflected in analyst forecasts, and sell stocks after negative earnings revisions, because history suggests that more bad news is still to come.

For example, a stock's price may rise only slightly when company earnings first improve because analyst estimates lag. By buying on early signs of earnings upgrades, behavioral finance portfolio managers would profit when the rest of the market recognizes a stock's true worth. In the same way, selling early may at times help managers cut losses and redeploy assets in more promising securities.

Lastly, the market anomaly from overconfidence is valuation. Investors tend to label past winners as "good companies" and thus good investments. But in practice the overpriced stock of a good company is rarely a good investment. As investors rush to buy a stock that was a past winner, they drive up the stock's price, causing it to become overvalued. Conversely, if a company repeatedly has delivered poor results, investors may become disillusioned, overreacting to the past and ignoring valid signs of improvement. It may be poised to deliver good results, but the company is overlooked and its stock undervalued.

The investment strategy for valuation is to seek to uncover overlooked investments, particularly from undervalued stocks that may be neglected for irrational reasons.

Client Opportunities

We have shown that understanding behavior provides greater probability for success via the markets. This is just as true when we examine these same behavioral biases in the individual client and his personal portfolio.

One of the most difficult jobs advisors have is helping clients avoid making these mistakes over and over again. This is no easy task because these biases are hard- wired into the human thinking process and many times one fails to recognize mistakes even when falling right into them. Simply put, it is not easy to control our clients' responses to the market.

However, if you can recognize these behaviors, understand how they can lead the client askew and, most importantly, have strategies that can help preempt these behaviors, you and your client will be successful.

Bad Behavior

When people make decisions, they tend to base them far more on what has recently happened and ignore longer-term data. Recency effect is what is often responsible for causing investors to make shortsighted decisions based on greed and fear. Many of you have probably witnessed this first hand. For example, how many of your clients believed that real estate was the "only" investment to make in the last few years? Well, if you compare the return of the S&P 500 to the return of residential real estate over a 20-year period (see Is Real Estate So Good? below), you may have a different opinion.

When you hear your client say, "Once it gets back to where I got in, I will?? 1/2 ," you know your client is anchored. She is making decisions based on information that is not directly relevant, typically based on a single fact or figure (e.g., short-term performance or a company's previous earnings). Then the client will typically manipulate new information (either positive or negative) to justify her beliefs. Anchoring can cause clients to have unrealistic expectations about an investment's future prospects--whether good or bad.

Investment overconfidence occurs when a client tends to exaggerate his ability to control and manage his financial portfolio. This bias is very common among corporate executives. Many times they are overly optimistic about their company's stock potential due to their "contribution" to the stock price. You might think that experience would make a person more realistic about his capabilities, but alas, research shows this not to be the case. Why? The human reaction is to protect one's ego, which often leads to forgetting failures (or thinking of them as being outside our control) while remembering successes (which were driven by one's own ability).

In all cases, because of irrational beliefs clients lose focus on long-term goals and avoid taking the action required to maintain a coherent investment strategy. In the end, clients become dissatisfied with their investment performance and their advisors. It's no wonder, then, that a recent Spectrem Group report found that one in five affluent households said they had changed primary advisors in the past three years.

Here lies the opportunity. If you understand human behavior and how to control bad behavior, not only should you keep existing clients (and have the chance to gain more wallet share), you will be positioned to capture those unsatisfied households. Clients look to us to protect them from their emotional selves. If we have the temperament and the tools to do this, we will truly be the advisor of choice.

Susan L. Hirshman, CFP, CPA, CFA, CLU, is a managing director for JPMorgan Asset Management in New York. In that position, she develops strategies to provide wealth solutions to the affluent market. She can be reached at susan.l.hirshman@jpmorgan.com.

Reprints Discuss this story
This is where the comments go.