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Behavioral Finance Tested By Extraordinary Times

Tom Burroughes, Group Editor , April 30, 2020


The discipline of behavioral finance has evolved over recent years, and the massive economic changes wrought by COVID-19 give examples of how the insights are being put to work in the wealth management industry. There is still plenty of room for development and education, people working in the field say.

Human emotions are being pulled about a lot at the moment, and no wonder. Consider the following: Market slides, economic lockdowns and angry words exchanged between China and much of the rest of the world; daily headlines of COVID-19 deaths, rising unemployment and canceled cancer operations. 

The upheavals caused by the pandemic have hit people across a number of fronts, and one obvious result has been the heavy fall in market indices since the start of the year. The worst of the rout saw broad indices fall by as much as 30 per cent or more. As of the time of writing, indices are down by around 15 per cent. That’s not as dramatic as the 22 per cent fall on the October 19, 1987 stock market slump on a single day. Or, to take another example, the dotcom era saw stocks crash by almost 78 per cent from their peak. But even if markets recover eventually, investors had a rude reminder of how fast things can move. And because of that, the lessons from a growing discipline known as behavioral finance remain hugely relevant. 

Behavioral finance tries to delve into the real drivers of human conduct to understand events such as market booms and busts, and why people can allow biases to lead them into mistakes and other issues.

A hope that some BF advocates have is that advisors and their clients will put these insights to work, learning to be more resilient during tough times and avoid panic and costly errors. It turns out that the behavioral finance revolution has a while to run before it becomes part of investors' mental furniture, however. 

"A lot of advisors could have been better prepared than they are," Greg B Davies, PhD, who works Oxford Risk, which delivers insights drawn from behavioral finance for the industry, told this news service.

Hopefully the COVID-19 saga will give behavioral finance a big push, said Davies, who before working at Oxford Risk had created his own consulting firm Centapse, and prior to that, worked for a decade at Barclays, heading its behavioral finance team.

Davies argues that while the pandemic has shocked people, it should not be viewed as a “black swan” event, because the world has been shaken already by health crises such as SARS, Ebola and Swine Flu.

Across the Atlantic, Jon Blau of Fusion Family Wealth, a US wealth manager, said that behavioral finance “is at the core of our being as a business”.

“We specialize in helping investors learn to make rational decisions about money under conditions of uncertainty – which is all the time.” ….”Certainty doesn’t exist anywhere in nature”,” he said. In terms of how to prepare clients for a shock, one should think of it as a lifeboat drill. “You need to know where all the safety equipment is long before the bow goes into the water." 

Be prepared
The idea of being prepared, of learning how to be “anti-fragile” (to borrow a term from the writer Nicholas Taleb), is an important BF building block. 

"You need to prepare yourself in advance. You need a contingency plan. Understand your financial personality," Davies said. 

The tools and approaches that people should have considered in the good times to prepare for a crisis aren't going to be of much use if they haven't prepared first. 

Davies mentioned parallels with how the military thinks about preparing for stressed situations, such as the idea of "redundancy", of having people used to doing other persons' jobs if they need to. A problem is that this sort of "redundancy" understanding does not feature in a modern, growing free market economy, with its focus on efficiency and a complex division of labor. 

The key question that many investors and advisors will have is how to use these insights for their advantage. 

"Anyone who is still accumulating wealth has an advantage. They are not in a hurry and can use this to their benefit,” Davies said. 

If people are still earning they are in a position to invest at lower valuations. Many professional investors, on the other hand, are forced to trade, so are in some ways at a disadvantage, he continued. 

Another pointer is not to watch short-term market moves but concentrate on longer-term goals. Shut out the “noise”, Davies argues. 

Fusion’s Blau concurs. 

Blau highlighted the mistake of investors getting out of a down-market and thereby missing out on any rally, which given long term outperformance of equities is a classic mistake.

“The question to ask is `what’s the price one needs to pay to benefit from equity investing' - volatility!” he said. 

He said investors make three major errors: Conflating risk with volatility; sellers of businesses think the task of wealth management is to preserve capital, but ignore the falling purchasing power of money and people think differently about buying equities than they do when buying and selling decisions around every other item.

“Investing successfully is a big challenge….there is a tug of war between one’s faith in the future and fear of it,” Blau added. 

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