He goes on to say, "Certainly, the perspective and experience of a professional money manager can be of great value to an investor. But I believe the behaviorists have made the point quite convincingly that professionals and non-professionals alike can exhibit nonrational behavior in making investment decisions. The MMI's statement seems to suggest that somehow 'careful analysis' is an antidote to nonrational behavior. This implies that nonrational behavior is the same thing as emotional behavior and that it can be reined in by the application of intellect and critical thinking."
MacKillop says there may be some truth to that, but also believes one of the great insights of behavioral finance is that "critical thinking" and "careful analysis" can be very much affected by nonrational thought processes, too. "In other words, professionals must grapple with their behavioral issues just like the rest of the investing public," says MacKillop. "There are certainly many good reasons to use separate accounts, but I'm not sure that behavioral finance is one of them."
Separate accounts aside, how can advisors apply the understanding of investor behavior to create portfolios for clients? First and foremost, BFT puts the notion of risk back into investing, according to wealth manager Martim de Arantes-Oliveira, a principal at H&S Financial Advisory LLC in Menlo, Calif. "Portfolios must be a reflection of process and discipline," he says. "Risk management is the primary function of portfolios. For all parties concerned, it emphasizes the need for that discipline and process in asset management as a way to mitigate-not eliminate-the innate irrationality and inconsistencies present in human decision-making, i.e., it revives the idea of uncertainty of outcome."
Lambert says his firm does not use BFT to outwit the market. "Instead, behavioral finance helps us create portfolios that clients will be satisfied with in good times and bad, and in keeping clients in the parts of the market that are appropriate for them," he explains. "It sometimes requires an advisor to be more flexible in portfolio construction, or to turn away a potential client because there is a mismatch in philosophies."
Financial psychologist Gurney says that she has observed a relationship between investment preferences and the "money personality styles" of clients. Her Moneymax Profiling System was developed to help investors (and advisors) become aware of, and take responsibility for, the money personalities and traits that drive their behavior. Says Gurney, "Often advisors find out what they need to know [about investor behavior] after the fact rather than during the investment process."
Some suggest that many advisors and money managers themselves are the obstacles to putting BFT into practice on any level, because they sometimes fall into the traps of "I know all the answers" or "I don't have time to spend on all this psychology." Invesco's Paul Power says we all can be our own worst enemy. "As professional money managers, one way we avoid that trap is to have multiple portfolio managers look at stocks to buy AND sell. For example, if a particular stock was suggested for purchase by portfolio manager A, and it isn't performing well, it is helpful to have portfolio manager B review the security with a fresh perspective," he explains. "This helps remove emotion from the decision-making process."
Investor psychology is a complex business-difficult to define and even harder to understand, concludes the MMI paper. The first step toward avoiding behavioral errors is understanding the behavioral influences that can cause them. And since most investors find it difficult to identify-much less correct-their own strengths and weaknesses, advisors and managers can create value for clients, thus reinforcing the important role that advisors and managers play in an effective overall wealth management strategy.
MacKillop perhaps says it best: "Behavioral finance is in its early stages. I do not think that even its most ardent supporters would claim that it perfectly explains market behavior or that it can be widely employed by the typical investor to gain a consistent investment advantage or beat the market. However, behavioral finance can certainly make advisors and money managers better investment counselors. By understanding nonrational behavior and working to help clients overcome it, advisors and managers can do a great service to their clients and increase their chances of reaching their long-term objectives. Anything that can contribute to that effort should be widely embraced by the investment community."
The Prospect Theory
Kahneman and Tversky presented groups of subjects with a number of problems.
One group of subjects was presented with the following dilemma: