Podcast Center
Video Center
Webcasts
Resource Center
Events
May 01, 2006 at 04:00 AM
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.
