From the September 2014 issue of Investment Advisor • Subscribe!

Investor Behavior by the Book

A collection of articles presents the state of behavioral finance and economics

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An anthology of behavioral finance articles shows advisors what they're up against when working with clients. An anthology of behavioral finance articles shows advisors what they're up against when working with clients.

As you might imagine, people send me more books to review than I can possibly read. And, truthfully, despite their hype, many don't offer much in the way of useful information for advisors. Occasionally, though, I’ll get an email from a publisher about a new book that looks interesting. This was the case with “Investor Behavior: The Psychology of Financial Planning and Investing,” a collection of articles compiled by H. Kent Baker, professor of finance at American University's Kogod School of Business, and Victor Ricciardi, assistant professor of financial management at Goucher College.

My interest was piqued by my long fascination with the relatively new discipline of behavioral finance and its even newer cousin, behavioral economics. For those who have been in a coma for the past 20 years, back in the late 1980s, some economists became uncomfortable with the general economic assumption that people tend to act rationally when it comes to their finances. (I know, financial planners have been aware of this fallacy since the early ‘70s; academics tend to catch on more slowly.) Some of them thought it might be interesting to study what investors actually do in given situations; when it turned out that most of us are far less rational than previously thought, a new area of study was born.

Sensing that the fruits of this research could yield valuable insights into how financial advisors might work with their clients more effectively, I’ve tried to keep up with the new research. Some insights have indeed been useful, such as programs like those offered by Loring Ward (see “My Conversation With Harry Markowitz: MPT and Behavioral Economics”). Yet I’ve been largely disappointed that behavioral finance hasn't been able to tell advisors more about how clients think. My hope was that Baker and Ricciardi's book would fill that gap.

Toward that end, I have to admit to being somewhat disappointed. Out of some 30 articles by different authors, only a couple deliver information tailored for use by practicing advisors: “Policy-Based Financial Planning: Decision Rules for a Changing World” by Dave Yeske, managing director, and Elisa Buie, CEO of Yeske Buie; and “Advising the Behavioral Investor: Lessons from the Real World” by Gregg Fisher, founder of Gerstein Fisher. There's also a good piece by Joseph Rizzi, president of Macro Strategies LLC, called “Post-Crisis Investor Behavior: Experience Matters,” which talks about how the experience of 2008-2009 shaped the investing tendencies of Gen Y.

With that said, this is by far the hardest book review I’ve ever written. I keep finding articles that, while not directly applicable to financial advice, are too interesting not to read. For instance, I had to pry myself away from reading about the emerging profession of financial counseling, only to get sucked into the socio-economic roots and implications of behavioral economics for another 20 minutes.

Then, under the premise that veteran financial planner Lew Altfest surely would offer some nuggets for his brethren advisors, I started reading his chapter, “Motivation and Satisfaction.” Instead, Altfest combined Modigliani's “life cycles” and Maslow's hierarchy of human needs with the “humanism” of Lutz (conflicting desires and developing a meaningful life) and Heylighen (self-actualization) to lay a theoretical foundation for the “life planning” movement of George Kinder and others. Interesting to be sure (it cost me 50 minutes), but a bit pointy-headed for most of the financial advisors I know.

I resolved to focus my efforts on the advisor-centered chapters of “Investor Behavior” when the book fell open to “The Surprising Real World of Traders’ Psychology” in which Denise Shull of The ReThink Group Inc. and trading psychologists Ken Celiano and Andres Menaker combined “social brain theory” with neurochemistry, human physiology, Freudian psychology and fractal theory to explore the effects of securities traders’ unconscious minds on their “judgment, skills and behavior” while making trades. The two case studies they cited to support their conclusions are must-reads for anyone who manages investment portfolios.

As for the articles that will actually help advisors in their client work, Rizzi's article highlights research that confirms the existence of generational biases that have been shaped by economic events: “The financial crisis of 2008-2009 with its 50% drop in stock market value is seared into the collective investor memory—especially generation Y investors,” he wrote. “[Younger] investors are more focused on reacting to macro developments than asset fundamentals. The shift from ‘return on capital’ to ‘return of capital’ underlies the move away from equities into perceived lower risk fixed income by certain investor groups.”

Did you get that? Those “Gen Y investors” that everyone is so breathlessly talking about attracting as clients are likely to be the most risk-phobic generation since my parents’, which lived through the Great Depression of the 1930s.

Fisher, chief investment officer and co-founder of Gerstein Fisher, opened his article with the famous 1933 quote from President Franklin D. Roosevelt during the depths of the Great Depression: “The only thing we have to fear is fear itself.” Fisher summed up his article by writing, “Overcoming clients’ emotional and cognitive biases in investing is both vital to their long-term wealth creation and a perennial challenge for financial advisors.”

Rather than an academic, Fisher is a practicing advisor. Consequently, he offered some real-world insights into the mistakes that clients tend to make—or want to make—and some outside-the-box solutions to overcome them. He started off by recasting the problem in a way that he's found makes it easier for his team to remember their mission: “We don't have people with investment problems; we have investments with people problems.” While he cited common investor mistakes such as failing to rebalance, chasing yield and underestimating the impact of inflation, he also explored the less talked about failure to consider a client's income stream as an asset; one that requires at least as much—if not more—offsetting diversification than their other holdings.

His unconventional approach is also evident in the considerable body of research he cited debunking the advantage of dollar-cost averaging versus lump-sum investments. Fisher suggested that “sub-optimal” investment strategies can also be the best investment strategies. “Instead of debating [whether MPT or behavioral finance strategies are better], an investment advisor should borrow from both. The result will be an investment portfolio and strategy that may be suboptimal from an MPT standpoint, but may be the right approach for the investors. In other words, sometimes ‘the right portfolio’ isn't the right portfolio.”

He used an example that shows how “based on information about a client, as well as experience with other clients in similar situations, an advisor might conclude that this client would panic and sell equities at a major loss at the market bottom. As a financial advisor, the best case may be to recommend that this investor pay off their mortgage and student loans before investing in risky assets. Again, no financial optimizer would recommend this strategy.”

Finally, one of the dynamic duos of the financial planning world, veteran planners Yeske and Buie, wrote: “Practitioners not only need an understanding [of behavioral finance concepts] but also practical tools. Policy-based financial planning is one such tool, offering a framework and approach that allows practitioners to craft decision rules that can keep clients committed to a consistent course of action.”

Based on their 2011 paper, Yeske and Buie provided a six-step process for creating effective financial planning policies for each client:

  1. Engage in the discovery process in which the financial planner learns about the client's personal history, values, beliefs, goals and resources.

  2. Identify planning areas and best practices required by this client.

  3. Combine goals with best practices to create a proposed policy.

  4. Test the policy: Is this a good policy?

  5. Test-drive the policy with the client and listen to their feedback.

  6. Conduct periodic reviews and updates checking for changing circumstances.

The couple concluded: “Financial planning policies are structured decision rules that can act as a touchstone for both clients and their advisors and allow for rapid decision making in the face of a changing environment.”

In addition to extensive citations of relevant research in each chapter, “Investor Behavior” also includes a detailed timeline of publications on investor behavior from 1841 to the present. For advisors who are interested in keeping on the cutting edge of behavioral finance, it's a must-have. But be warned: For info junkies like me, this is like heroin.

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