Modern financial markets present a multitude of challenges to financial planners and to investors struggling to build portfolios that can reduce risk and enhance returns.
To boot, the pitfalls of investor behavior that impede and complicate achieving final goals can make things even more difficult for advisors. However, many advisors are making a concerted effort to understand these behaviors and learn how they can apply behavioral finance to their practices.
That effort would become easier, though, if the financial planning industry were to collaborate with the scientific community. After all, the final goal –- to understand the investor psyche and help investors have better financial outcomes -- is the same for all involved, says John Hailer, CEO of Natixis Global Asset Management in Asia and the Americas, so sharing information and findings would benefit all.
“Our industry has an opportunity to get better globally and to the extent that we can collaborate [with scientists], we have a chance to do better and help our investors do better,” he says.
To that end, Natixis has recently committed to fund a three-year, $1 million research project at the Massachusetts Institute of Technology (MIT) focused on investor behavior.
Dr. Andrew Lo, Charles E. and Susan T. Harris Professor at the MIT Sloan School of Management and director of the Laboratory for Financial Engineering (LFE), will lead the project, which will be conducted using Natixis data (the firm has collected several years worth of data that track the behavior of individual investors, financial advisors and institutional investors, and that is based on responses to more than 500 survey questions by more than 30,000 participants).
The main goal of the project is to create personal, individual benchmarks that take into account individual behaviors in order to improve investor participation and performance.
“We want to understand how the individual investor experience will influence their financial decisions,” says Lo. “We know on a general level how investors react to cumulative losses and gains ... but we are going beyond the general and after the much more ambitious goal of capturing behavior at the individual level.”
This new research program will begin by studying the industry practice of using an index as a benchmark. Hailer and Lo believe that most indexes are outdated, reflecting neither the current markets nor serving as proper benchmarks for investors.
“We want to develop a more modern approach to benchmarking based on an individual’s unique circumstances as well as current market dynamics,” Hailer says.
In a first instance, Lo and his team will be developing algorithms to mimic irrational but common investor behavior in an attempt to quantify the systematic mistakes made by investors. Then, they will attempt to create new and customizable benchmarks and indexes that adapt to changing market conditions and behavioral challenges at the individual level.
“We know that a lot of investors everywhere in the world make emotional decisions, but if you have a portfolio designed to help mitigate risk and volatility, based on an individualized index, you can sleep at night, regardless of what is happening in Ukraine and in the Middle East,” Hailer says. “We believe strongly in a durable portfolio construction model that focuses on helping investors develop a personal, outcome-based approach to achieve investment success.”
“We believe strongly in the idea that one size does not fit all and we want to be able to fully understand how the individual investor experience and behaviors at the individual level will influence decisions,” Lo says.
Lo and Hailer hope to be able to make their findings available to the general public and provide individuals and financial advisors with tools they can use to model investor preferences more directly.
“We are hoping that everyone in the [financial planning] ecosystem can use [our findings],” Lo says.
His Laboratory of Financial Engineering is a partnership between academia and industry created to drive advances in capital markets, risk management and financial technology research. Outside of academia, he is the founder, chairman and chief investment strategist of AlphaSimplex, a Cambridge-based investment advisor focused on the dynamic relationship between risk and return in the financial markets. The firm manages more than $4 billion in assets for institutional and mutual fund investors.
Natixis Asset Management currently has around $900 billion of assets under management.
Check out 6 Behavioral Finance Principles Advisors Need to Know on ThinkAdvisor.