But how can a portfolio be customized without understanding the client's behavioral biases? Customization is the hallmark of a separately managed account, says Boulder, Colo.-based veteran wealth management and SMA consultant Curtis Greenlaw. "Careful analysis emanating from client fears and expectations-in addition to their biases-is crucial," he says. "These biases shouldn't overwhelm the portfolio management process, but acknowledging and understanding them should be useful to advisors and managers in addressing important issues of suitability, as well as more effectively managing client expectations."
But are these behavioral technologies, often described as cutting edge, helping managers in their quest for better investor understanding and communication and more skilled portfolio management? Perhaps, says Scott MacKillop, co-founder and president of Trivcon Consulting based in Evergreen, Colo. "In some sense, these are really not cutting-edge strategies at all. Many traditional value investors look at the world very much like the behaviorists. They believe that investors overreact to events and behave in other nonrational ways with the result that securities are mispriced, if only temporarily."
Such strategies have been around for many years, says MacKillop. "Firms like Fuller & Thaler are trying to directly apply the teachings of behavioral finance to investing in ways that could be characterized as cutting edge. They apparently have had some success, although I don't think they have discovered the Holy Grail yet. Once they do, everyone will copy their approach, and they will have to move on to discover new ways to exploit investor nonrational behavior. Based on their track record, it looks like investing a portion of a client's assets in their funds would have resulted in a pretty decent return."
Lambert doesn't mince words about the exploitation of BFT. "This goes to the heart of the issue of active versus passive," he says. "For active managers this is another tool in decision-making. For the passive adherents, it is just another heresy."
Consultant Curt Greenlaw believes behavioral finance merely incorporates another variable to assess an investor's visceral attitudes and response to risk. "Describing it as cutting edge is ironic," he says. "It is inane to believe that any mathematical 'model' or cursory questionnaire can adequately measure risk. So, it would be worthwhile and prudent to entrust a portion of a portfolio to a separate account manager who truly seeks to better understand their clients' motivations, fears and biases."
James N. Whiddon, a CFP licensee and CEO of JWA Financial Group Inc. in Dallas, offers a slightly acerbic viewpoint. "The behavioral insights [strategies] that money managers are using may be cutting edge, but the clients are the ones who eventually may bleed," he says.
He adds that a concept still taught in business classes continues to ring true: "The market can remain irrational longer than investors can remain solvent." Whiddon believes that some money managers create 'products' that are seemingly based on valid academic research such as behavioral economics. "But in truth, they are often cleverly disguised marketing approaches," he says. His bottom-line approach is a "long-term adherence to MPT (modern portfolio theory) with deep and broad diversification across multiple asset classes. It is still the best way to invest."
Although cynics still abound-primarily among the more traditional guardians of efficient-market theory-the beliefs presented by behavioral theorists are increasingly gaining acceptance in the economic and financial communities. However, University of Chicago finance professor Eugene Fama, a widely respected efficient-markets theorist, criticizes behavioral finance theory. In a 1998 essay in the Journal of Financial Economics, Fama rebuts the view that behavioral finance might replace efficient-markets theory. The field tends to attract people who are not very good statisticians, says Fama in the article, and he argues that behavioral finance hasn't shown that the cumulative tendencies of individuals have an impact on world prices. Fama continues to argue that "data-mining techniques make it possible to locate patterns whose significance is nonetheless questionable, if not irrelevant."
But some remain unconvinced. "Perhaps this is true, but how does he explain the week or ten-day lag in market pricing of a stock after the announcement of a particular news event?" asks Kathleen Gurney, Ph.D., and CEO at Financialpsychology.com. She also is founder of the Center for Family Finance, in association with the University of South Florida in Sarasota.
The debate about MPT and BFT continues to stir controversy as industry scholars question and/or disagree. Even some true behavioral finance believers have some doubt as to the consistencies of the psychological studies supporting the ideology, not to mention the validity of its benefits for separate account holders as mentioned in the MMI paper. SMA specialist MacKillop says he admires MMI's efforts to enlist the behaviorists in the cause of promoting separate accounts, but he feels they may be "stretching the teachings of BF a bit in the process."