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Get Ready, Get Set: Behavioral Finance

Client relationships can be just as important as investing performance.

Michael M. Pompian, 07/31/2008

Since the popping of the technology stock bubble in March of 2000, we've all heard a lot about behavioral finance--which is commonly defined as the application of psychology to finance. But for many financial advisors behavioral finance is still an unfamiliar and unused subject. There are some financial advisors, however, who have taken the time to read and learn about behavioral finance and use it in practice with good results. Why have they done so? These advisors realize that being successful is just as much about building great relationships with clients as it is about delivering investment performance. And they have observed that behavioral finance can provide tools that can help them "get inside" the head of their clients in order to build mutually beneficial relationships.

Interested in learning more? I hope so--because in the coming months, I'll write monthly columns on the practical application of behavioral finance. I have seen the benefits, and it really works!

But before we delve into the details, I'd like to introduce myself. For two decades, I have been a financial advisor to private clients through many different market environments. In fact, three months out of college into my first job in the business, I experienced the crash of 1987--what a start! Since then I have advised clients through several recessions, bull markets, financial meltdowns, and, importantly, the technology bubble of the late 90s. And over that time I have developed outstanding long-term relationships that I attribute in part to my interest in and use of behavioral finance.

When my career began, I was happily serving mass-affluent clients. It was tough slogging: making cold calls, working weekends, and presenting to clients and prospects at the dinner table; but there was a thrill involved in turning a new prospect into a satisfied client. Over time, as many advisors find, I wanted to serve fewer clients and get to know them better. The desire to build deeper relationships with fewer clients won out over the challenges of the mass market.

After researching what was important to wealthy families--the "soft issues" such as family relationships and investor psychology that come along with inherited wealth--I began to research behavioral finance. As luck would have it, at that time the technology stock bubble was in full force and provided a window into irrational investor behavior and behavioral finance as a discipline began to gain attention. I read works from the leading behavioral finance thinkers: Kahneman, Thaler, Shefrin, Statman, Tversky, and others. Later, I realized I could apply the theories behind behavioral finance in a practical way to my practice, by diagnosing my client's biases and trying to predict them and course-correct where necessary. My goal was to use the foundational work by these well-known scholars and teachers to build a practical model for my practice. But it wasn't until I had a quiet evening out with my wife-to-be, when we were talking about the Myers-Briggs test she had taken at work that day, that I got the idea to write about the subject. The thought process was simple: Doesn't it make sense that people who behave differently (who have different personality types, for example) might approach investing differently? After conducting research on the Myers-Briggs personality inventory, I worked with a colleague, John Longo, to interview 100 investors and give them a Myers-Briggs personality type test and a test for investor biases. Our results were published in the Journal of Wealth Management as "A New Paradigm for Practical Application of Behavioral Finance: Creating Investment Programs Based on Personality Type and Gender to Produce Better Investment Outcomes."

As I continued my work, however, I found that while I was able to help clients better understand and improve their investor behavior, there was not a lot of interest among advisors in conducting Myers-Briggs tests with their clients. That was just too much information--and too much time taken away from the practice. If behavioral finance were to be helpful to the majority of financial advisors in creating better investment portfolios, three key challenges had to be tackled. First, advisors needed a guidebook to teach them the basics of behavioral biases and how to diagnose them in clients. Second, even if advisors could diagnose client biases, they needed to know what to do with that information. For example, given a certain set of behaviors, should they attempt to change the behavior of the client to match the allocation that's right for the client, or should they change the allocation to match the client's behavior? Third, the industry needed a common behavioral finance language. Behavioral biases, as then articulated, were not user-friendly because there was not a widely accepted set of terms for describing and communicating these biases to other advisors or to clients.

In March 2003, Longo and I published a second paper in the Journal of Financial Planning titled "The Future of Wealth Management: Incorporating Behavioral Finance into Your Practice." In that paper, readers were given some practical advice on how to adjust a client's asset allocation because of irrational biases, assuming that they could recognize these irrational behaviors in their clients. The ability to recognize biases, of course, was a big assumption; I noted in the JFP article that there was no handbook on how to diagnose and treat behavioral biases. That's when I began to write such a handbook, published in 2006 by Wiley, Behavioral Finance and Wealth Management. The book defines 20 of the most common behavioral biases advisors encounter in their daily client work and describes how to diagnose and treat these biases. It also establishes new terminology to more effectively communicate behavioral finance concepts with clients.

However, even after all this work I realized there was still a missing piece! Even if an advisor had been trained in irrational biases, knew the terminology, and understood how to apply this knowledge to his or her clients, he or she still needed a way to make the process of advising the client efficient, almost second nature. In other words, advisors needed to be able to easily recognize investor behavior at a high level so they could quickly and effectively diagnose and treat that client's irrational behavior. So I created a process that categorizes clients into one of four behavioral investor types. The process is called Behavioral Alpha. The word "alpha" is used for two reasons. First, the dictionary definition of alpha is "first" or "the beginning." It is my belief that before an asset allocation is suggested, financial advisors need to take inventory of a client's behavior. Secondly, in the context of the financial world, the word "alpha" has become synonymous with describing performance above expectations. By using the Behavioral Alpha process the advisor will enjoy performance results that exceed expectations because clients will be able to more comfortably adhere to an allocation that has been custom-designed for them. A paper on Behavioral Alpha will be published in the Journal of Financial Planning in October, so look out for that.

If you have any questions or comments, please feel free to e-mail me at mpompian@behavioralalpha.com.

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