Real Life Strategies for Applying Behavioral Finance Principles

Being able to help in the right way means advisors need to have the right tools at hand

For financial advisors who want to incorporate the theories and principles of behavioral finance into their practices, finding applicable solutions is often a challenge. There’s no question that advisors who want to do things right with respect to behavioral finance have to be knowledgeable of the science behind it, says Richard Peterson, managing director at San Francisco-based behavioral finance research and consulting firm MarketPsych, but more importantly, they need to be able to work with user-friendly methods and tools that allow them to apply behavioral finance to every day, real life.

While Peterson’s entire body of work is based on the research he has done in the field of neuroscience (which in its avatar of neurofinance is arguably the bedrock of behavioral finance), his firm, MarketPsych, has maintained a singular focus on the applicability of behavioral finance. Since the crisis, it has become even more clear that markets, the people in them and the plans that are created to get the best of them are not always rational, and irrationality as a product of what happens in “that big black box that’s our brain,” has to be taken into account to understand why people do what they do and to prevent them from making mistakes, Peterson says. But being able to help in the right way also means that advisors need to have the right tools at hand, he says, and this is where firms like MarketPsych come in.

Over the past seven years, the company has worked on integrating the competitive advantages derived from behavioral economics into data and signals for financial firms and advisors. The MarketPsych team has developed proprietary text analysis software that identifies and quantifies economically predictive sentiments such as optimism and pessimism, or tones such as uncertainty or surprise, and, more specifically for financial advisors, it has compiled a “fear index” that measures how much fear – the most prevalent emotion vis-à-vis financial markets – is in the market.

“A lot of people externalize their emotions and this is the kind of tool advisors can work with to help clients who come in and say ‘I am terrified,’” Peterson says.

MarketPsych’s data feed includes over 400 sentiments, tones and topics related to 7,000 U.S. stocks. The data is available through the company’s application program interface (API) and via graphical tools that allow for immediate visualization of trends in online conversation.

The company provides up-to-date graphic visualization of the emotions associated with: stocks that have had a spike in relative levels of investor fear; stocks that MarketPsych has identified as potentially peaking on a given day; the 10 most loved stocks; and stocks surrounded by rumors of fraud or corporate corruption. It also offers a scatter plot of the top

30 most buzzed-about stocks, which depicts their past 10-day price return versus their 10-day average sentiment, as well as the sentiment surrounding ETFs and the overall market.

Peterson and his team are looking to continue developing their emotions-based models and systems, and are currently working on creating a personality test that both investors and their advisors can use.

“Customers will take a personality test and give us their financial advisor’s email address,” Peterson says. “We’ll analyze the tests, be able to tell what sort of fears and sentiments these individuals are most susceptible to, and we’ll then email the advisor, telling them about the areas they need to work on with a particular client.”

Peterson thinks it’s important for advisors to encourage their clients to take this test in order to gain objective insight into how their clients’ minds are working. But he also thinks it’s important for advisors themselves to take the test, as this will allow for comparison between the thought processes/sentiments of both parties, and highlight discrepancies.

“Overall, we believe that both advisor and client taking the test can ultimately help in building a stronger relationship between them,” he says. “Working from the psychological angle is the most important part of the business and it helps a great deal in being able to retain clients and work with them properly as an advisor. If an advisor wants to keep growing their profession, there is no question that they have to be integrating behavioral finance methodology into the practices, because this is what will enable them to really understand people. And really understanding people means a lot more than just being a real good people person: It means having the kind of relationship that enables you to see where people are going wrong and how to help them. Kind of like the difference between a good country doctor and a specialist.”

In addition to his work at MarketPsych, Peterson also serves as associate editor of the Journal of Behavioral Finance, and he has published widely on the subject in academic journals and textbooks. His book, “Inside the Investor's Brain,” was published to high acclaim in 2007. He has also performed post-doctoral neuroeconomics research at Stanford University, and is board-certified in psychiatry.

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