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 blasÃ© 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 blasÃ© 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.
Daniel Egan is Head of Behavioral Finance, Americas for Barclays Wealth.