Except for the occasional tome or lecture from one of the industry's wise men, you don't hear quite as much about behavioral economics these days.
At the risk of falling victim to a correlation-equals-causation trap, we would suggest that's partly because the stock market has finally gotten back on track and investors have dismissed worries of irrational behavior at the moment. But while the S&P 500 has posted a healthy 11% gain over the past year, those wise men would tell you that this is precisely the time to be on guard against irrational behavior-in yourself and your clients.
So in that spirit, Bank Investment Consultant once again offers our behavioral roundup. Similar to last year, we collected a small group of academics and industry experts to talk about behavioral economics and how advisors can use these concepts in a pragmatic way. We emailed our panelists questions and then compiled their answers.
This year we have Dennis Ruhl, managing director and CIO of U.S. behavioral finance at JPMorgan; Greg Davies, managing director and head of behavioral finance and investment philosophy at Barclays; Joseph Coughlin, director of MIT's AgeLab; and Michael Liersch, director of behavioral finance at Merrill Lynch.
Here, we present excerpts from these email conversations.
Bank Investment Consultant: Behavioral economics spent years as an academic issue in the "ivory tower." What took so long for it to become a more mainstream topic?
Dennis Ruhl: Research surrounding behavioral economics started in the late 1980s when it was recognized that certain market anomalies pointed to flaws in the widely supported efficient markets theory. Unfortunately, painful market events, such as the crash in 1987 and the tech bubble in the late 1990s, were necessary for people to realize that there was more to consider when making financial decisions than just the efficient markets theory. It took time for people to accept that markets can act irrationally, and that this irrationality is caused by human behavior.
Greg Davies: Behavioral economics is a field that is inherently interdisciplinary. It challenged approaches that people were familiar with, and in which there was considerable investment. This made it difficult for the field to make itself felt practically in an industry built on existing specialist knowledge. Also, for a long time, the ivory tower was more interested in describing behavior and pointing out what was wrong with traditional models than it was with developing practical alternatives.
Joseph Coughlin: Thinkers who strongly support the idea of a rational model of decision-making have dominated economics. They are not entirely incorrect but they are incomplete in their approach. Other disciplines in the social sciences have known for some time that emotion, problem definition and elements of what may be described as irrational greatly impacts our decision-making. These disciplines, however, have not traditionally enjoyed, or sought, the close link to business that economics has had for decades. Consequently, a more complete understanding of decision-making from research to practice has lagged.
BIC: Is it a mainstream topic yet? Some financial firms are using it, but it seems that others are paying lip service at best.
Michael Liersch: Behavioral finance is a popular topic that garners a lot of interest, but I do not think it is mainstream yet. I would say most investors have never even heard of behavioral finance. If they have heard of it, the message they have received from academia or the media is that behavioral finance equates to typical investor mistakes that cannot be overcome or managed.
At Merrill Lynch, we have discussed behavioral finance as a way to empower investors to better understand what their goals are so that we can tailor an approach that will make them feel most confident in their strategy. Ultimately, behavioral finance is incorporated in all elements of how we do business-from our thought leadership to our wealth management tools to our advisor training and ongoing development programs.
Ruhl: As a topic of discussion, we believe that behavioral finance has reached mainstream, as investors are open to considering some of the ideas and principles that behavioral finance is based on. The timeline from discussion and consideration to more systematic, widespread application of these principles will take time. That said, adoption is increasingly visible in such examples as the book Moneyball and some of the principles applied by the Obama campaign, as well as in college classrooms.
Davies: Sadly, it's easy to talk a good game about behavioral finance without doing much about it. There are lots of cute anecdotes and stories about how we're all hopelessly 'irrational' in amusing ways. Recounting these stories endlessly is much easier than the hard work and investment to turn this knowledge into practical business applications, so all too often, lip service is as far as it gets.
Coughlin: New thinking, even when validated with empirical evidence, takes years if not decades to be integrated into the mainstream. But, we are at a tipping point-a record number of retirees are coming, a changing regulatory climate, an uncertain economy and a disruptive demographic of better educated, highly demanding, but not necessarily informed, consumers are demanding change.
BIC: What's the biggest lesson that behavioral economics has to teach investors and advisors?
Ruhl: We believe there are two concepts that are extremely important for both investors and financial advisors to understand. The first concept is loss aversion-the theory that a financial loss is felt, psychologically, twice as much as a gain. So an asset that rises in value, but also has a high level of volatility, may be shunned by investors who feel that the smaller losses outweigh the larger gains. We believe this has caused investors to abandon equities for bonds today. They are still feeling the pain from their 2008 losses despite the fact that the S&P 500 is approaching highs witnessed in 2007. This shortsighted loss aversion could potentially hurt an investor's long- term investment performance if they purposely avoid asset classes because of the fear of loss.
The second concept is overconfidence. Overestimating one's ability to perform a particular task can be detrimental to investment performance in the long run. This concept applies both to the ability to choose individual investments as well as predicting the best times to buy and sell. This can lead to buying funds too hastily that have performed well recently and selling those that have performed poorly.
Davies: The biggest lesson is that investors wanting the best risk-adjusted returns is nonsense. What investors are truly after is anxiety-adjusted returns: the best possible returns, relative to the anxiety, discomfort and stress they're going to have to endure. Certainly, some of this discomfort comes from term risk: The chance that your portfolio may go down in the long-term is discomforting. But much of it arises from other sources, which may have nothing to do with the risk of the portfolio, including short-term drawdowns, lack of control, too much or too little information, or investing in assets they don't understand.
If we fail to consider these sources of anxiety in our portfolios, and chase only some classical notion of optimal risk-adjusted returns, we will not only make ourselves uncomfortable, but we will also fail to attain the very thing we're striving for.
Seeking the best anxiety-adjusted returns means sacrificing a little long-term financial efficiency to buy the emotional liquidity we need to endure the journey. It is better to aim for the attainable than for perfection.
Liersch: Investors should collaborate with an advisor to better understand the investment risks-and whether or not those risks make sense in the context of the investor's own goals and priorities.
Say an investor is at or near retirement, they can work with an advisor to identify their objectives and prioritize them based on their expenses and desire to feel safe. It is then that the appropriate risks to meet short- and long-run objectives can be evaluated.
In the early 2000's, there was a movement to apply behavioral finance as a way to harness "investor inertia." The notion was that investors could default themselves into strategies that optimized risk and return regardless of their essential needs, the risks they were comfortable with and their resource constraints. The problem with this approach is that it does not account for what happens when "the going gets rough." In other words, the only way an investor can ever receive the returns of an optimized portfolio is to stay invested (sometimes over a very long time horizon).
Coughlin: Behavioral economics can potentially inform people of their conscious and unconscious biases when making choices. Unfortunately, few consumers have the time to engage in careful mental gymnastics to ensure quality decisions. Today's consumer is rewarded in the short-term for speed. The volume, velocity and complexity of daily life crashes in on our capacity to assess how we may be making irrational choices-we simply must choose. Those who are too stressed by the options or overwhelmed by the information will choose not to plan, not to save, not to engage. Educating against the pitfalls of fast and fallacious thinking remains a strategic responsibility and opportunity for financial services and in particular the advisory business.
Behavioral economics should also be used to inform innovation in both financial product development and distribution. For example, product development has primarily been based upon managing risk and ultimately providing a desired income ("Help me achieve my number!") Research is revealing that while consumers are acutely concerned about 'their number' they are far more likely to understand and engage in discussions around products that are connected to concrete expenses rather than an ambiguous goal of a 'secure retirement.'
BIC: What's the single most useful concept in behavioral economics-framing, anchoring, loss aversion-for investors and financial advisors? And how so?
Davies: I'm resistant to the 'list' approach to behavioral finance. Really using this knowledge requires thinking hard about how these concepts link together, what underlying mechanism drives them and how they can be integrated with existing approaches from classical finance. The more we move away from looking for single concepts or biases to blame for apparently irrational behavior at any one point, the better.
That said, if I were to point to a single broad concept that I think is most useful, it is constructed preferences: the notion that we don't go through life with a stable set of preferences that we can somehow read in our mind's eye when faced with choices. Instead, our preferences are themselves constructed on the fly, and so are heavily influenced by context, environment, framing, loss aversion and current emotional state, as well as by the longer-term investment goals we like to think we're objectively targeting.
This has the important implication that much of what is often written off as irrational investment behavior is rather simply the expression of more transient constructed preferences.
Take, for example, an investor who holds a sensible, diversified portfolio in a period of extreme crisis. As the portfolio falls, the investor gets increasingly worried, panicked and stressed. Gradually, his reservoir of emotional liquidity dries up and eventually he sells at the bottom. The position of classical finance is that this is irrational. But if you're stressed and can't sleep at night, there is nothing irrational about selling at the bottom. Your constructed preferences at the time place a great priority on immediate emotional comfort. It is however, very expensive for your long-term financial goals.
The right question is not the classical one of 'How do I ignore my immediate emotional needs and focus solely on my long-term financial preferences?' Instead, recognize that you also have important short-term emotional preferences and recognize how to satisfy them with the smallest sacrifice to your long-term goals.
Liersch: The very premise of behavioral economics-that we are all human and cannot remove human tendencies from the investment process -is an extremely powerful concept. It is empowering to see clients recognize that they should embrace-rather than reject-their emotional needs with respect to investing in order to maximize outcomes. Making investing personally meaningful is what, in my experience, keeps investors invested.
Coughlin: The issue of framing is likely to emerge as one of the most influential concepts to change how we plan and invest in retirement. Clients are redefining retirement planning. Recent losses, market uncertainty and the realization that many will have to work longer than their parents means that they are now more focused on longevity planning-not retirement planning. Defined contribution plans and erratic markets mean that clients are looking for guidance about what to do in their sixth, seventh and eighth-plus decades as much as looking for products and plans that provide income alone.
BIC: How, specifically, do you use behavioral finance in your job?
Ruhl: As investors, we believe that while the market is efficient over long periods of time, over shorter periods the market can be inefficient. We believe that these inefficiencies are a result of human behavior, and to the extent that human behavior is persistent, these market inefficiencies will not disappear. We seek to build portfolios by identifying and exploiting these anomalies through a disciplined, dispassionate approach to investing. Based upon these principles of investing, we launched our core suite of four Intrepid Large Cap funds nearly 10 years ago. Since inception, all four have ranked in the top third in their respective Morningstar categories, which is a powerful testament to how the understanding and application of behavioral finance can fuel investment performance over time.
Davies: We use it in designing and implementing our global investment philosophy, in designing of products and investment solutions, in how we profile clients, in the quantitative methodology underpinning our asset allocation models, in understanding market movements and in how we communicate internally-and externally with clients and media.
Liersch: I have worked with subject-matter experts, advisors and clients at Merrill Lynch to build a proprietary assessment process-the Investment Personality Assessment-that helps clients and advisors identify a client's mind-set toward risk, his or her preferred approach to investing and his or her primary investment purpose. I primarily work with the firm's wealthiest clients to identify their concerns and goals so that we can collaborate to tailor an investment approach that is unique to the client's needs and aspirations.
Coughlin: The multiple disciplines that form the foundations of behavioral economics are core to my research at the MIT AgeLab. We are exploring and developing new approaches to engage people across the life span. Our work examines how individuals and their immediate social networks frame and make choices that affect their health and wealth decisions in older age. This includes the development of different methods to engage clients in discussing their 'futures' as well as techniques that inform how people seek trusted information to make complex decisions affecting retirement, caregiving, healthcare and related longevity costs.
BIC: Are there other lessons from behavioral economics that we haven't touched on yet?
Ruhl: The key is to learn how to increase the percentage of our time spent acting rationally versus irrationally. Investors have many techniques at their disposal to help guide them to make better long-term investing decisions, such as educating themselves as to what situations will typically lead to irrational decision-making as well as setting themselves rules to follow in advance to remove emotion from the equation.
Davies: Yes, two common perceptions are both inaccurate and harmful. First, that behavioral economics needs to be in opposition to classical finance -the traditional models have a great deal of value, and it is still important to have a normative baseline to measure behavioral interventions. The classical models provide the right solution under the assumption that you care only about long-term risk-adjusted returns. This has value, but excludes a lot of what is important to real, flesh and blood investors.
Second is the perception that behavioral economics is not rigorous, robust or quantitative. While much of the popularization of behavioral finance has been through easily accessible stories and anecdotes, this misses the decades of robust scientific research and quantitative modeling that underpins these stories. The danger is that behavioral economics comes to be seen as merely parlor games, undermining the efforts required to embed this new understanding to help investors make better choices.