Advisors are faced with the difficult task of addressing their clients’ human biases that can negatively affect how they make financial decisions, and consequently, their long-term investment goals.

“In order to best prepare for the inevitable battle that comes from working with clients that have these behavioral biases, it’s necessary to be armed with a basic background and understanding of the behavioral finance tenet,” says Casey Dylan, the director of investment communications at Symmetry Partners. These biases stem from natural human tendencies to act on emotion rather than logic, which is not the best approach for financial decision-making.

Symmetry, founded in 1994, takes an academic approach to investing to manage sophisticated portfolios built on logic, empirical evidence and respected academic research. We recently spoke with Dylan to get his insights about the firm’s academic approach and how behavioral finance can benefit both advisor and client. Following is a lightly edited version of that discussion.

Bank Investment Consultant: Why do you use academic approaches to choose investments?
Casey Dylan: We observed 20-plus years ago that research in academia was addressing the sources of returns in markets, as well as how investors harvest those returns. The research also looked at some of the issues investors run into that keep them from achieving those successful investment experiences. We’re very heavily reliant on academic research to really guide our thinking.

BIC: How do you use that research?
CD: The practical implementation of the research is on returns, and the sources of those returns help inform the construction of our portfolios. What we observe from the academic literature are the sources of returns for premiums on specific risk characteristics. When it comes to behavioral finance, we can build these fantastic investment portfolios predicated on the academic research to help us harvest these premiums over time. But if investors can’t stay seated long enough in those portfolios to reap the reward of harvesting those premiums, then that’s not a successful client experience.

For instance, we recognize that investors have a home bias, that’s well-documented. If you ask an investor in the U.S. ‘How’d the market do?’ their response is typically dictated by the S&P 500 or the Dow. But if you ask an investor in London, their response is going to be predicated on the markets in London. In 2014, the S&P 500 had double-digit returns, but investors opened their statements in January of 2015 and they said, ‘I know the S&P 500 had a banner year, yet I see single-digit returns to my well diversified portfolio, why is that?’ They suffer a cognitive dissonance from the tracking error of that home bias.

Casey Dylan is the director of investment communications at Symmetry Partners.
Casey Dylan is the director of investment communications at Symmetry Partners.

BIC: What do you look for in academic research?
CD: What’s interesting is the juxtaposition of the academic process vs. the traditional Wall Street model. If you think about the role of incentives on Wall Street, if you identify some unique characteristic that helps you understand returns to markets, is it in your best interest to share that publicly? Or is it in your best interest to take that information and utilize it to gain a competitive advantage over your peers? In academia, the incentive is to be the person to identify that unique characteristic, and then publish.

BIC: So how specifically does behavioral finance help you make investment decisions?
CD: An example might be dismantling the disposition effect, which is the tendency of investors to hold on to shares too long, juxtaposed against selling their winners too early. We find that that academic research has identified prudent, thoughtful, approaches that encourage them to stay in an investment portfolio for the duration so that they can again harvest those long-term.

BIC: Does using an academic approach go against the idea of using ETFs and a passive approach?
CD: Not at all, the academic approach is vehicle-agnostic. What you’re really trying to determine is where those returns come from. What are the characteristics of risk? And how do people behave given various sources of risk? That says nothing about passive or active. It speaks to the nature of risk and the premiums associated with it, and how we behave. You can build successful strategies using mutual funds or ETFs. I think what we’ve observed over time is as you can identify the sources of return and it lends itself to de-mystifying what previously had been thought to be alpha from active management.

BIC: Does your approach work best in a down market?
CD: First and foremost, a successful response to a market event begins before the event. When you first start to articulate your value proposition to a client – when you are onboarding them into your practice –setting realistic expectations is an important piece of that early engagement. So if a market downturn happens, remind clients what the long -term plan is. Remind them why it’s been put in place and what the data is behind that. If you start to observe them reacting with loss aversion or they start to anchor to specific pricing, you can identify what it is, articulate it for the client and help them understand this is a natural response as a part of the human condition.

BIC: Is there anything else you’d like to mention?
CD: Just one thing: Dalbar publishes an annual quantitative analysis of investor behavior and the findings are that the average investor underperforms by as much as hundreds of basis points annually. The question that we’re all forced to ask is: Why? In some cases, research points to underperformance of active management, in some cases it’s cost, and equally important, it’s investor behavior. So at the end of the day if we can help arm investors and their advisors with the tools to overcome the negative impact of investor behavior, we can recapture half of that underperformance that we observe all the time.