To put it bluntly, some of Margaret Starner's wealthier clients are thrill seekers. “It's sometimes boring to do the right thing,” says Coral Gables, Fla.-based Starner. “They need an occasional fix.”
So a few years ago, Starner introduced what she calls “serious funny money.” She'll take $100,000 or so of the thrill seekers' money — not a significant sum for these clients — and invest it in an untested new issue, knowing that the investment won't matter to the overall portfolio. Starner, whose Starner Group, part of Raymond James & Associates, has about $400 million in assets, says, “I'm always thinking about strategies that can help my clients, but still meet their emotional needs.”
Certainly, at least some of your clients must make financial decisions that don't seem entirely rational. They want to buy high and sell low. They hold on to positions much longer than they should have. They overestimate their ability to beat the market. And the list goes on.
Starner is one of a small, but growing, group of advisors who do more than just scratch their heads in exasperation. Instead, she's incorporating the lessons of behavioral finance into her practice. A discipline combining economics and psychology, behavioral finance turns one basic tenet of economic theory — that people make rational decisions when given the right information — on its head. Instead, its proponents hold that most of us do quite the opposite. Like Starner's clients, who want to invest in something simply for the thrill of it, people make financial decisions for a host of emotion-driven reasons. And, as a result, they often end up shooting themselves in the foot. In fact, investors' portfolios lose as much as 7 percent in value thanks to such behavior, according to Daniel Egan, head of behavioral finance at Barclays Wealth.
Only recently, however, has a critical mass of financial advisors started applying behavioral finance theory to real -life situations. In some cases, they're using sophisticated behavioral personality questionnaires supplied by their firms. In others, they're creating their own home-grown strategies. In all cases, “they're trying to neutralize the emotional side to help their clients make the most rational decisions,” says Sophie Schmitt, an analyst with Aite Group. At the same time, they all provide lessons in how you can start introducing behavioral finance into your practice, too.
Behavioral finance got its start in the 1970s with the publication of groundbreaking research by two psychologists by the name of Amos Tversky and Daniel Kahneman. Their findings focused on what they called prospect theory, which contended that investors are considerably more affected by losses than by gains of the same size, something called “loss aversion.” Since then, other researchers have pinpointed a wide variety of emotion-driven proclivities. For example, thanks to “inertia,” people prefer to stick with the status quo. “Fear of regret” inspires clients to make foolish investments simply because, say, their friends are all buying the stock. (For more on specific behavioral tendencies and how to address them, see sidebar on page 67).
It's in the retirement plan arena that advisors have done the most work applying behavioral finance to practical uses. The strategies rest on groundbreaking research by Richard Thaler of the University of Chicago and Shlomo Benartizi of UCLA in the 1990s into why participation in 401(k) plans tended to be lower than expected. The reasons lay in several key psychological principles: inertia, loss aversion, and myopia — a focus on short-term results — as well as plain old procrastination. To that end, they created a program with several elements. First, employees would need to opt out of a plan, instead of opting in. Then, they would commit to increase their contribution rate in the future. And the increases would coincide with a pay raise, so take-home pay wouldn't decline, thereby triggering loss aversion.
Of course, you don't have to stick with that approach completely. Take Jamie Hayes, an advisor with Fiduciary First in Maitland, Fla., who has tinkered with the strategy. About five years ago, she introduced the opt-out feature, along with a minimum contribution rate of 3 percent. Then, after working with the Behavioral Finance Institute, a think tank run by Allianz, she changed her approach, raising the minimum contribution rate to 6 percent and increasing the automatic increase from 1 percent to 2 percent. According to Hayes, the change didn't hurt overall participation and plan sponsors “love it.”
For other advisors working with individual clients, however, it's a bit more complicated. The best place to start is at the beginning of the relationship, creating a client profile that reveals individuals' proclivities and biases. For example, Denise Federer, a psychologist and founder of Federer Performance Management Group, suggests using what she calls a “structured behavioral interview,” in which you ask clients a series of in-depth questions that get at clients' “money beliefs,” everything from whether they worked during high school or college to how they like to spend their money now.
In some cases, your firm might be able to supply you with a questionnaire. For example, in 2007 Barclays introduced a financial personality assessment for its 250 advisors. With six dimensions, such as “composure,” or how easily a person gets stressed out, and “market engagement,” how comfortable they are with the world of investments, it aims to create an in-depth look into a client's emotional makeup. The idea is that advisors can study the assessments' results and pinpoint specific steps that can help clients avoid irrational behavior. Similarly, two years ago, Merrill Lynch introduced a 27-question questionnaire that gets at clients' investment personalities, for use in creating portfolios.
Once you understand your clients' proclivities, you can go about the task of addressing them. The central skill that's needed is framing — presenting investments and plans in a more appealing light.
Consider the results of a recent study by Jeffrey Brown, a professor at the University of Illinois, who looked at the effect of framing on investors' response to annuities. He asked more than 1,300 people over the age of 50 whether they'd prefer a life annuity paying $650 each month or a traditional savings account with $100,000 and 4 percent interest. For half the participants, he described the annuity as providing an income for life. For the other half, he presented the annuity as an investment with a $650 return. The result: About 70 percent in the first group chose the annuity, because it seemed to provide a guaranteed lifetime income, while only 21 percent in the second group made the same selection, since it presented the possibility of giving up the money to their insurer should they die early.
“It has to do with getting people to adopt a different perspective so they can make the moves they need to make,” says Frank Murtha, co-founder of MarketPsych, a New York-based consulting firm specializing in behavioral economics.
He points to a widow in her 60s, whose husband invested a considerable portion of their wealth in his company stock. While the woman recognized that wasn't the best strategy, she also found it hard to diversify, since the current strategy represented her husband's wishes and his very identity. About a year ago, her advisor painstakingly showed her how they could diversify and what the result would be — more income and safety. He also proposed literally framing the original stock certificates, so she could have a visual representation. She agreed to make the change.
Perhaps the most important part, however, is talking to your clients — and being willing to take the time to do so. In fact, addressing the emotional side of your clients' decisions can be highly time consuming. For one thing, advisors and psychologists agree that just telling people they exhibit certain behaviors won't inspire them to change. Says Federer, “You have to work through it with them.”
Case in point: Not long ago, Starner saw a recently married couple facing a dilemma. They had bought a home around the same time that the husband had decided to start his own business. But the wife feared they wouldn't be able to afford their house and they were at an impasse. After a long conversation, Starner was able to get to the bottom of what the couple really was feeling. He wanted to use the time before they had children to see if he could develop his business. She, on the other hand, had grown up learning that owning a home was immensely important. In the end, they sold the home and just in the nick of time: The real estate market collapsed shortly thereafter.
You also can't expect to introduce the approach overnight. It takes considerable research and preparation. Consider Brian Lampsa, a Chicago-based advisor with Raymond James who has about $400 million in assets. He says he studied the field for years before introducing it to his work with individual clients. (He started using it for his 401(k) clients about seven years ago.) In the meantime, he attended conferences and workshops regularly, in addition to doing his own reading.
Still, he reports that the efforts have been worth it, especially in forging stronger relationships with clients, who also seem more satisfied — and relieved. He points to his use of bucket theory, aimed at stopping retirees from engaging in panic-induced selling. “My question was, how do I design a program that motivates the retiree to stay put and understand they need this equity exposure regardless of what the market is doing at the moment,” he says.
With that in mind, he divided his clients' portfolios into four pools, arranged according to when the funds would be needed, with different investment approaches for each. In one, which contained cash, would be money needed in five years; in the second, funds would be drawn on in five to 10 years; in the third, 10 to 15 years; and the fourth, which consisted entirely of equities, more than 15 years. According to Lampsa, he's had considerably fewer panicky calls since introducing the approach. “They have a much better understanding of what's happening,” he says. “And that lets us do our work.”