Behavioral economics and behavioral finance have become buzz phrases in recent years. They've grown in popularity partly because of a populist underpinning. Namely, economists have been wrong for decades.
Even if the main lesson were a simple reminder not to necessarily accept conventional wisdom, it would be a valuable wake-up call. But since this is a cross section of social sciences, here at Bank Investment Consultant we thought that any job that's social at heart should be able to benefit from this provided the messages came from people who knew what they're talking about.
So we went out to find four such experts to write about a variety of topics in that cross section. You'll find their articles in the following pages.
Joseph Coughlin, the director of the MIT AgeLab, studies social trends to predict what the future holds for an aging America. He takes a broad look at economics—that is, decision-making—and spells out what the future might look like for the purveyors of financial advice.
Christopher Blum, another of our contributors, is a managing director and chief investment officer of JPMorgan Asset Management's U.S. Behavioral group. He looks at fund flows and tells us when (historically) is a good time to buy. And why that (ironically) is when most people sell.
Greg Davies and Daniel Egan are both from Barclays Wealth. Davies writes about the price of comfort and how clients' decisions that appear to be irrational may actually be the right one for them. And Egan writes on some of Barclays findings as it delves into the behavior of clients. Why clients made certain decisions and how to help them improve.
We think you'll enjoy their insights and we'll soon have longer versions of these articles on our website, so check back.
Longevity Creates New Business Opportunities
By Joseph Coughlin
Life used to be predictable. So was retirement. For many, life was a near linear progression from one stage to the next—birth, childhood, school, young adulthood, work, marriage, retirement, and yes, end of life.
Retirement was a time to relax and enjoy the rewards of a lifetime of work—both for those in the workforce and those who worked in the home. It was a time to enjoy family, friends and frequent visits to sunny climes. Simple.
Retirement planning was to ensure adequate financial resources from a combination of pensions, social security and savings to pursue a life delayed.
But this is not your father's retirement. Both life and retirement are confounded by new complexities stemming from changing demographics and the new socioeconomic context of old age. Most of yesterday's retirees did not face the real possibility of one's lifespan outdistancing one's "wealthspan."
A 60-year-old today is likely to live three to six years longer than a 60-year-old retiree from 30 years ago, meaning most will now be looking at life well into their 80s. Most striking is the reality that within the 50+ population those 85 and older are the fastest- growing cohort.
More than years separate the generations. The new generation gap is expectations. The baby boomers born between 1946-1964 have more education than any previous group of Americans. The increase in college education has given rise to a generation of researchers. That combined with the capacity of the Internet to make everyone an "expert" is contributing to an attitude that with enough information and time they can figure it all out. That, in turn, raises expectations for what professional advice can and should deliver. Moreover, 60 years of economic growth and technological innovation have persuaded many to expect their life to be not only longer, but also better.
Family life has always been a crucial foundation of retirement. But today family dynamics are neither stable nor supportive of traditional retirement. Baby boomers had far fewer children than their parents: 1.8 offspring, on average, compared to 3.8 for their parents' generation. And even if there are children, they are increasingly likely to move to a different region or state to pursue economic opportunity. This limits the nearby availability of trusted help as well as the loving duties of grandparenting.
Moreover, while divorce rates have dropped nationwide, divorces among Americans over 50 have more than doubled, making relationships with children uncertain, later life finances more complicated, and the likelihood of living alone greater. Without adult children readily available, older adults will have to find and finance formal help to remain independent.
Ironically while care may be in short supply for future retirees, it is very likely that Americans in their 50s, 60s and even 70s will have more people to help care for than previous generations. For nearly one in four American families informal caregiving is a regular responsibility, especially for near retirement or retirement-age baby boomers. The average family caregiver is an adult daughter or daughter-in-law well into her 50s. Balancing these responsibilities hinders her ability to save and plan for her own retirement ahead.
The context of retirees' financial futures has also changed dramatically. Baby boomer parents could plan on the stability of pensions and social security. The next wave of retirees must manage defined contribution plans, the poor timing of the global economic downturn, continuing discussions of an unclear future of social security, and the rising costs of healthcare—all making for an uncertain financial future.
In light of financial uncertainty, the retirement strategy for many is to continue working. Indeed, an explosion of new business started by middle-aged and older Americans has changed our perceptions of an innovator. Entrepreneurs are no longer just wiz kids with an idea and a gadget, but include an energized older generation of Americans.
Older age is no longer about a predictable retirement that needs financial security alone. It is about managing an unprecedented evolving multi-act life and creative thinking is required. Here are a few transition points to help you move into tomorrow's longevity management business:
• Financial advice has always sought to link client goals to financial objectives. The next generation client lives in a different context and expects more than the traditional linear approach between money and goals. Baby boomer women, in particular, are now seeking someone with informed and empathetic expertise to identify the range of what's next. For example, the implications of long-term care decisions on the emotions and finances of family members, or how a new chronic condition may change life plans and future costs.
• Most clients tend to believe they will live a little longer than their parents. And chances are good they will live much longer than they anticipated. Advisors and product developers must develop powerful longevity visualization tools to help clients understand that the longer you live, the more likely you will live even longer—making delayed retirement, annuities and innovative life insurance products that enable access to income in extreme old age part of a longevity strategy.
• Financial products are about money. However, the new longevity client is seeking solutions. Longevity product innovation could begin with 'purposeful annuities' that link annuity income to trusted providers of services that may have once been provided by an adult child or spouse. These might include funds to provide home maintenance and modification from a branded home services firm; or financial management of living expenses for an elderly parent living far away; or end-of-life care and death services that both finance and provide the freedom to choose any service provider.
• Lifestage models are useful to understand the first two-thirds of life, but later life today is a work in progress. Finance is no longer about security alone, it is about linking informed advice and novel financial products that enable the start of something new—a business, going back to school or a career change, for example.
Longevity management is more than planning for money in later life. It requires a creative consumer-centered approach to build a platform of longevity education, financial products, planning services and the trusted solutions necessary to navigate a longer and better life tomorrow.
Recent Memory Effect Hurts Stock Performance
By Christopher Blum
Natural disasters, the European debt crisis and social and political upheaval in the Middle East have created recent market volatility and contributed to an ongoing sense of uncertainty.
With the credit crisis and ensuing market correction of 2008 still fresh in the minds of investors, the focus of many has been on capital preservation. The derivatives market is indicative of this prevailing mindset, showing that investors are currently spending 12 times more money to protect against a downturn in stocks than to capture the upside from a potential rally.
This behavior among investors is not surprising. Studies show that people tend to strongly prefer avoiding losses versus acquiring gains. Odds are often ignored and rational decision-making is abandoned as a result of people's aversion to loss. Unfortunately, this behavior can stifle investment goals, which generally require a long-term commitment. Saving to send a child to college can take 20 years. Building a nest egg for retirement can span the length of a career, lasting 30, 40 or even 50 years. Yet many investors with these goals base their investment decisions on recent history.
Risk should be calibrated to meet investment objectives. Over the long term, insufficient exposure to risk can be just as detrimental to investment performance as excessive risk. In the current market environment, an emphasis on capital preservation could leave college savings and retirement nest eggs underfunded. Very simply, investors cannot avoid taking risk and achieve their longer-term investment goals. An analysis of investor behavior, however, suggests that they ratchet up risk and lower risk at inopportune times.
Consider fund flows. More money starts to flow into stocks as the S&P 500 Index increases. Conversely, investors pull money out of stocks as the S&P 500 drops. In both cases, they are assuming that the most recent trajectory of stock prices will continue.
Based on stock returns from Jan. 1, 1950 through Oct. 31, 2011, this behavior is counterintuitive. During this 61-year period, risky assets provided less downside risk at longer investment horizons. For example, the worst one-year return for U.S. small-cap stocks was -45.9%. Expand the investment horizon and the downside risk for investors is sharply reduced. The worst 10-year rolling return for U.S. small-cap stocks was 3.2%. Held for 20 years, the worst return an investor would have experienced is 8.1%. Despite this evidence, investors still buy and sell stocks based on short-term fluctuations in stock prices.
This behavior is referred to as the "recency effect" in behavioral finance, a field of study that emphasizes the importance of human psychology in financial markets.
In addition to the recency effect and loss aversion, behavioral finance examines how herd behavior, overconfidence and representativeness impact investment decisions.
Herd behavior describes how individuals in a group can act together without planned direction. The term pertains to the behavior of animals in herds and to human conduct during activities such as stock market bubbles and crashes, sporting events and even everyday decision-making. Stock market trends often begin and end with periods of frenzied buying (bubbles) or selling (crashes). Many observers cite these episodes as clear examples of herding behavior that is irrational and driven by emotion—greed in the bubbles, fear in the crashes. Individual investors join the crowd of others in a rush to get in or out of the market.
Foibles of Human Nature
Meanwhile, overconfidence, a behavior regularly exhibited by individuals in which they overestimate their knowledge, underestimate risks and exaggerate their ability to control events, leads investors to try to time the market, often causing them to sell winners too early and hold on to losers too long. Representativeness describes how people tend to judge the probability or frequency of a hypothesis by considering how much the hypothesis resembles available data.
Many poor investment choices are a result of human nature. Behavioral finance suggests that humans are wired to consistently make some decisions that are not in their best interest. Opportunistically rebalancing a diversified portfolio over a long-term investment horizon can guard against this and help investors meet their investment objectives.
Investors underexposed to risk in relation to their long-term investment goals may want to consider allocating more assets to equity strategies. The stock market's current price-to-earnings ratio is below its historical average, which has generally been a good purchasing opportunity for long-term investors. A study of the S&P 500 Index's from 1945 through 2011 indicates that buying stocks when the market's P/E ratio was below average resulted in an annualized return of 15.9% for the next three-years. This compares to 6.8% for investors who bought when the P/E ratio was above its historical average.
Per behavioral finance some investors may ignore this data, concentrate on market uncertainty and maintain a focus on capital preservation. Others may realize that their portfolios are not properly balanced to meet their long-term investment goals and take advantage of an opportune time to buy stocks.
Paying for Emotional Comfort
By Greg Davies
How much are you prepared to give up in order to sleep better at night? A strange question, perhaps, in the context of investing. But it's one that needs to be asked (by you) and answered (by your client.)
Classical finance theory makes no room for such luxury when considering how to best deploy personal assets in the quest for investment returns. But classical finance theory often fails to capture the real-life concerns of investors. In fact, the failure of economic theory—and subsequently the financial services industry—to address this question is one of the primary sources of poor advice to investors.
The traditional approach of the industry has been to create "optimal" portfolios that presupposes that the investor is completely rational at all times.
The industry has been effectively washing its hands of responsibility for a very large part of what it means to invest well. It's not enough just to know what to invest in. It's also necessary to effectively execute on this knowledge and to control one's very normal emotional responses. By ignoring the important role of emotions, traditional portfolio solutions not only make investors uncomfortable, but they also potentially result in poor decision-making and lower performance.
As creatures of emotions, when we're stressed we make decisions that make us more comfortable. We pay too much attention to the short-term; we overreact to market movements; we invest in local assets or ones we're familiar with and shun better risks that are less familiar; and we retain large portions of our wealth in cash, unused and unproductive.
A sequence of comfortable short-term decisions often does not add up to optimal long-run performance. In other words, these behaviors drag down our long-run returns.
But bear in mind that these reactions are perfectly normal. So how do you incorporate them into an overall investment strategy?
First, identify the issues at play. Despite what some behaviorists say, these reactions are not only natural, they are often rational. Yes, they can reduce long-run returns. But we get something in return—we get to sleep at night!
Many investors sold out in despair at the bottom of the markets in late 2008 and early 2009. In one sense, this was a perfectly reasonable thing to do. If you're stressed and anxious about the markets, selling provides a sense of relief. This is short-term emotional comfort purchased at enormous financial cost, however. Once you've sold out of a turbulent market, it's almost impossible to get back in quickly. You lock in the losses and miss the potential market rally.
This brings us back to the question: How much should your clients pay for emotional comfort? Traditional finance says "zero." Emotion is to be controlled, not pandered to. But when we aim for perfection, we're betting against the obvious and powerful force of human fallibility.
One way of purchasing emotional insurance is simply to take less risk. But this also reduces long-term returns, sometimes dramatically. When offered a choice between the perfect portfolio and not investing at all, many choose the latter because it's more comfortable. In doing so, a moderate-risk investor in a globally diversified portfolio may be missing out on as much as 4% to 5% over what she'll get from holding cash. This isn't irrational because emotional comfort is important—but it's expensive. The right approach is to accept the need to sleep well at night, but then try to achieve this as cheaply as possible.
This may mean keeping a reasonable portion of your wealth in cash; purchasing downside protection in the event of extreme market moves; or even accepting some inefficiency in your portfolio.
All of these can help you invest productively for the long term and get some sleep. Some people need a little more emotional comfort than others. But no one needs to pay 5% to get it.
Beyond the Black and White of Financial Profiles
By Daniel Egan
For decades, financial advice has been defined by where to invest and what markets are available. Incremental improvements have occurred, but they have hardly been revolutionary. They have not been the type of changes that could significantly increase performance or an investor's satisfaction.
In the 1970s, psychologists began studying financial decisions in earnest. Their work established a new basis for understanding how and why we make decisions the way we do. This body of knowledge has grown and is now being translated into practical applications for investors.
Take for example, the stubbornly low contribution rates to pension and savings plans. In the 1990s, two behavioral finance researchers—Richard Thaler at the University of Chicago and Shlomo Benartzi at UCLA—achieved startlingly high increases in contribution rates by using our human tendency to discount future events steeply. They had individuals commit a percentage of future raises to their savings, rather than current income. In less than three years, average savings rates increased from 3.5% to 11.6% for plan participants. Through psychology, the researchers were able to overcome inertia and create an outcome that all stakeholders thought was excellent.
Long-standing research backs up the belief that you can't beat the market. Most individual investors systematically underperform a passive investment strategy. However, a key understanding is that there are specific, and different, reasons why two individuals would underperform. Financial advisors need good diagnostic tools to understand their clients' preferences and weaknesses in order to craft solutions. Defining and measuring these differences require significant knowledge of psychometric testing and behavioral finance, as well as how to use them effectively.
Here at Barclays, our global team of behavioral finance experts are charged with improving client and advisor decision-making. After a full year of research and validation, we released a multidimensional financial personality assessment.
One key insight is that our attitude toward investing is only partly described by the concept of "risk tolerance." Consider real estate investors who are familiar with a sector and understand how they can manage risk in a very direct way. Yet financial markets represent a novel and unfamiliar source of risk. These individuals have low market engagement, a measure of discomfort regarding financial markets.
The concept of composure is also key. While some investors might feel comfortable taking on a significant amount of risk when considering the long run, they may vary in how they'll react to risk and losses in the short-term. Individuals with high composure are more likely to be blasé about investment performance and interim performance, rebalancing infrequently and holding too many legacy positions. However, it also means they can bear greater illiquidity in their portfolio emotionally, and therefore pursue liquidity premia without risking distressed selling in times of stress. They may be so blasé that a good advisor would be the one initiating portfolio reviews and sell decisions.
Those with low composure are more likely to be stressed by periods of heightened volatility and losses (even if they don't need the money in the near future). They're more likely to change their allocations in response to recent market events, and may suffer from "narrow bracketing," focusing on individual investments at the expense of the portfolio as a whole, leading to dissatisfaction with performance. Such individuals may benefit from investment strategies that outperform during down markets and reduce their tendency to churn their portfolios.
Rather than using behavioral biases to beat the market, advisors should focus on helping investors outperform themselves. With diagnostics, we can leverage our individual strengths and mitigate our weaknesses to achieve better results.
The results are not just better in an objective, risk-adjusted return sense—they result in a more comfortable journey, a two-fold return on an investment in understanding ourselves.