Protecting Your Clients from Themselves

Understanding behavioral finance can give you the edge

By Glenn Freed

Key Takeaways:

  • Behavioral finance uses theoretical and empirical academic research to explain why investors often do not act rationally.
  • Understanding both the “how” and the “why” of irrational investor behavior can be invaluable to wealth advisors.
  • Research shows that many individuals are overconfident, under-diversified, short-sighted and easily swayed by the media.
  • Wealth advisors have a duty to protect clients from their basic instincts.

If the world were full of “rational” individuals who could maximize their wealth while minimizing risk, there would be no need for wealth advisors. Rational individuals would assess their risk tolerance and then determine an investment portfolio that met their ideal level of risk aversion. However, we know that most individuals are not capable of being rational. Now, you would never want to tell your clients that they are incapable of being rational about their wealth, but it is important to point out why a wealth advisor plays an important role in reminding individuals how to be “smart” about their wealth.

Behavioral finance encompasses a body of theoretical and empirical academic research that seeks to explain why people, especially investors, do not act in a rational manner. Understanding behavioral finance can be invaluable to the elite wealth advisor. Think of the moniker “behavioral” as describing how and why individuals behave the way they do.

First let’s look at the “how.” Here are some findings, based on empirical research, that explain how investors tend to behave when they don’t have expert guidance to help them:

  • They invest in under-diversified portfolios.
  • They trade actively with high turnover and high transaction costs, which have a significant drag on their returns.
  • They are influenced by where they work and live. They invest heavily in the stock of their employers, and they tend to invest in stock of companies based in their home country, and even companies located near where they live.
  • They are often influenced by companies getting lots of media attention. They tend to buy, rather than sell, companies that are mentioned positively in the news.
  • They tend to sell their winning investments, while holding on to their losing investments way too long in hopes of getting back to “breakeven.”
  • Men tend to trade more often than women do. Men’s excessive trading leads to lower returns relative to women’s.

Now let’s look at why individuals behave a certain way, which is based on theoretical research. Here are some theories:

  • Psychology research supports the theory that individuals are generally overconfident. The overconfidence of individuals explains why they trade actively and have under-diversified portfolios.
  • Psychology research supports the theory that individuals believe they are better than the average individual, which makes them overconfident.
  • Psychology research supports the theory that investing in stocks is a sensation-seeking activity for many individuals. It’s a form of entertainment and gives many individuals an adrenaline rush that’s akin to what drives people to gambling.

Behavioral finance literature serves as a reminder to elite wealth advisors like you why it so important to protect your clients from themselves. Safeguarding a client’s wealth is a fiscal and social responsibility. To many individuals, the appropriate stewardship of their wealth is a responsibility to one’s self, family, house of worship, community organization and country. Be proud that you are your client’s wealth psychologist. Teach and reinforce responsible wealth management behavior with your clients.

About the Author

Vericimetry is an academically based, quantitatively structured investment adviser providing capacity-constrained asset class strategies to an exclusive group of elite financial advisors. Website: www.vericimetry.com.

Glenn S. Freed, PhD, CPA, PFS, is a leading investment and tax expert in the investment management industry. Dr. Freed is the Chief Executive Officer of Vericimetry Advisors LLC, which intends to make necessary filings to become an investment advisor registered with the Securities and Exchange Commission during 2011. Dr. Freed has 25 combined years of experience in investment management, tax and accounting research, education, and tax advising. He received a PhD from the Graduate School of Business at the University of Southern California and a BS in accounting from the University of Florida.

Phone: (818) 813-1351