The Barclays wealth management division has pinpointed more than 1,200 investor types along with specific strategies for how to advise them.
Though several financial companies have embraced the idea of behavioral finance, Barclays is a leader in applying this approach. It recently unveiled its way of understanding clients better and delivering advisory services best suited for them. Toward that end, its team of psychologists and behavioral experts had spent four years developing and refining a questionnaire designed to gauge investors' attitudes toward the markets, risk and financial decision-making. More than 10,000 clients and prospects worldwide have taken the test.
At Barclays, its behaviorists in London and the U.S. (and soon to include Asia) tried to connect the academic concepts of behavioral finance with clients' portfolios. "We try to address each person individually instead of typecasting," said Michael Liersch, a vice president of behavioral finance and investment philosophy in the wealth unit. "In the Americas, we started rolling it out in 2009. Reps started taking the test in 2009. We train them and have them internalize the concepts."
The questionnaire measures six aspects of a financial personality: three risk attitudes — risk tolerance, composure and market engagement — and three decision-making styles — perceived financial expertise, desire for delegation and belief in skill. Each is measured along a sliding scale; taken together, they illuminate a person's financial profile.
The goal is to give advisers a more fine-grained assessment of the client's mind-set concerning money, Liersch said.
For example, a client could genuinely have a high-risk threshold for the long term yet be prone to impulsive selling during short-term market turmoil. In that case, he would have high risk tolerance but low composure, said Joseph Dursi, a vice president in Barclays' portfolio consulting group. Dursi's unit builds customized portfolios using the insight gained from the questionnaires, as well as from the client's situation and objectives.
That type of client is not unusual. Entrepreneurs often fall in that category, Liersch said. They are not averse to taking risks because, by definition, they have put their own capital at stake. But they are also focused on the short term as a result of their day-to-day oversight of their companies.
That can be good for an entrepreneur, but it makes for an antsy investor, who often will end up selling at a market low point.
Using traditional methods, such a client, identified as having a high risk threshold, would probably have been put into volatile investments. And just as probably, he would have conveyed his low composure just after a 5% market dip.
The Barclays wealth unit, using its model, would suggest using managers who exhibit good "downside capture," that is, those who do well in bear markets. Another option would be the use of structured notes to smooth returns, Liersch said. "When you look at the academic community, behavioral finance has become very well respected," he said; "we wanted to get ahead of this and offer it to clients."
Dursi noted that, recently, Barclays has gained clients who made such mistakes and grew frustrated with their former advisers.
Constructing a unique portfolio takes personal situations into consideration, too. For instance, if a client owned a sugar plantation, the test would ratchet down its commodity suggestions and put a premium on stability to help offset the risks in the client's business. Though a recommended commodities allocation might usually be from 3% to 6%, in this case Barclays might recommend a 1% or smaller direct exposure to commodities. It also might suggest smaller overall portfolio risk.
This benefits both advisers and clients, Liersch said. It helps solidify a long-term relationship or, in the case of a prospect, enables the adviser to "walk in their shoes." It may have taken years to identify a problem in the past, but now Barclays can understand someone's financial personality in an hour, he said. Several meetings would still be needed beyond that point to come up with solutions, however.
Another common scenario is a high-net-worth husband and wife or partners who invest together but have misperceptions of each other, Liersch said. "When you are dealing with two clients who are working together but not communicating with each other, it inhibits the adviser from being able to better serve the client," he said.
In one couple's case, one partner was very low in perceived financial expertise and, as a result, lacked confidence. The other partner was just the opposite and came to dominate portfolio decision-making. The less confident "partner never spoke up but just stayed up late at night worrying about the portfolio and was unhappy with the portfolio movements," Liersch said. After the couple took the assessment test, they moved toward a more moderate portfolio that both liked.
Years after making its debut as a fringe field in institutes of higher learning, behavioral finance's acceptance in financial institutions is still hit-or-miss. It can be used broadly in two ways, said Harold Evensky, the president of Evensky & Katz Wealth Management in Coral Gables, Fla. One is to find investment opportunities when the entire market has acted irrationally and mispriced stocks or bonds. The other is to try to improve practice management by identifying flawed decision-making.
It is the latter that applies to financial advisers, but it is still proving difficult to apply in a concrete way, said Geoff Davey, a co-founder and director of FinaMetrica, an Australian risk-profiling company. The challenge, he said, is that, though behavioral finance reaches interesting conclusions about people in groups, these groups still harbor a wide range of individual preferences.
Another company that is making headway is the Allianz global investor division, which created a Center for Behavioral Finance last summer. A board of academics is shaping its overall strategy, but it is up to Cathy Smith, the center's co-director, to carry out these concepts. "The past two decades have given everyone the notion that we're missing something," she said, "and that something is human behavior. We're taking this from the ivory tower to the office tower."
Many concepts in behavioral finance are "deceptively simple," she said. One that has resonated in the real world is committing a bigger allocation to a 401(k) before getting a pay raise. This imposes no immediate pain in the sense of reducing take-home pay, she said, so the idea is more palatable.
That idea was dubbed "Save More Tomorrow" in a report that reinforced the importance of behavioral finance for Allianz, Smith said. The center targets the full life cycle, not just retirement, she said.
Allianz is preparing a white paper to deal with the challenges advisers face, Smith said. It is informally dubbed Behavioral Finance 2.0, she said, since it will take the subject beyond research and observation to improve customers' financial outcomes.
One current challenge to advisers is a lack of trust, she said, which also relates to behavioral finance. A lot of advisers feel that they have just one more chance to regain trust or risk losing clients for good. Yet they are paralyzed by the fear of making a bad decision that would precipitate client departures rather than hoping to do well enough to solidify client support.
A behavioral specialist might say these advisers suffer from their own form of "regret aversion." So Allianz's center is working with advisers to help overcome that reluctance. One way might be to get an adviser to commit himself or herself to an invest-for-tomorrow plan, Smith said. This would be similar to "Save For Tomorrow," but advisers would be persuading clients to move cash gradually into longer-term investments.
Others say there is reason to worry about the fragility of trust. Studies have shown a direct correlation between trust in a society and GDP growth, said Richard Peterson, a managing director in the MarketPsych consulting firm. Trust in the U.S. financial industry has been on the decline for 22 years, according to Peterson's research.
MarketPsych uses a linguistic analysis to measure trust by monitoring up to 200,000 conversations per day on social media websites, financial blogs and in chat rooms. An uptick in trust appeared in October but then fell again in November after news of mortgage foreclosure scandals broke, he said. His trust research is an offshoot of behavioral scrutiny more generally, which also uses a linguistic analysis to identify stock-buying opportunities.
Another behavioral finance tool that advisers can use to more effectively deal with clients is "framing," said Robert Seaberg, a managing director and the head of wealth advisory resources at Morgan Stanley Smith Barney. Framing is the way that an investment or any issue is presented to an audience and how its presentation can affect perceptions of it.
Seaberg uses annuities as an example. When dubbed "investments," 75% of people do not want to buy them, but, described as "income," they elicit the opposite effect — 75% want them. An element of the adviser's job is similar to that of a therapist, he said. By framing client conversations in various ways, he said, Morgan Stanley's advisers can conduct their own experiments to see which presentation works better.
"Human beings are not rational," Seaberg said. "They do things that are irrational, even incompetent, and that affects markets." One example is holding on to losing stocks too long, he said.
Some experts scoff at the notion that behavioral finance is too esoteric to be useful. "I've heard this idea a lot, and I think it's funny," said Dan Ariely, a professor of behavioral economics at Duke University and one of the field's main proselytizers. People naturally use the ideas behind behavioral finance. "Everyone uses psychology, even if they pretend they don't," he said. "Investors naturally think that they know more than other investors," he said, invoking a notion that behavioral science warns against: overconfidence.
Ariely even questioned whether financial institutions have an incentive to delve into behavioral finance and help clients improve decision-making.
Institutions benefit from market opacity, he maintained, because it helps them persuade clients of the value they add.