As readers of this column know by now, I’m a fan of behavioral finance. I think it offers a lot of lessons to advisors as a way to understand investor psychology.
The behaviorists say that we were blinded in the 2000s to the fact that our irrational actions were setting us up for a fall. (Bear with me, this has implications for advisors.) When the fall occurred, and markets melted down in 2008, it was viewed as a confirmation for behavioral economics. After all, the markets were unable to correct themselves. The invisible hand had failed.
But as I’ve thought about it lately, I’ve begun to question whether it’s really an entirely new way to understand the world, or whether it’s simply an examination of one specific issue in the “old” economics.
I’m not sure it’s fair to say the old economics missed the mark on human behavior. More accurately, it didn’t bother trying to understand it. Despite being a social science, it glossed over human behavior with the fuzzy concept of utility. Utility was traditionally understood as well-being, or happiness, for lack of a better term. People, of course, would inherently maximize their utility by following their own self-interests. And usually, that was that. If the issue were considered any more deeply, their actions were deemed rational—how else could they maximize their utility? You may not understand their decisions. You may not agree with them, but this was their utility function and they knew best how to maximize it.
Now we recognize that’s not always the case. We may want to maximize our utility, but we simply don’t always make reasonable decisions. Sometimes, we don’t even know exactly what we want. Just look at all the people who overextended themselves on homes they could not afford. Look at the banks that offered those loans. Even more to the point of irrational decisions, look at the interesting social experiments that illustrate how people think. Consumers can get a number in their head (any random number in some cases) and then allow that number to determine their perception of a product’s worth.
So in many cases, people are not, in fact, maximizing their utility. And when we take an irrational step, we usually don’t realize it because we rationalize our own actions along the way.
So what can you do it you have that sort of irrational, rationalizing individual as your client? What if you have a hundred of them?
Well, the good news is that they really haven’t changed. (After all, we are talking about human nature, and that’s not going to change just because the Ivory Tower has a new theory.) If you had a good handle on your clients before, you still should.
There may be only so much you can do in some client situations. But recognize that their decisions aren’t always rational. (Or your own decisions, for that matter.)
It isn’t enough to simply ask if they are risk averse and then check off a yes or a no. And it may not be enough to simply take them at face value if they say they can handle a 10% decline in their portfolio.
Really delve and spend some time to come up with their true risk profile, as well as their self-perceived risk profile.
And what about segmenting your clients by behavior? It’s common to segment by how lucrative they are to your bottom line. This is where the idea of the “80/20 rule” comes from. And as a business, you certainly need to know where your profits are coming from.
But to truly serve the clients, it would also be nice to know how their behavior separates them into groups. This group is made up of the real risk takers; that group thinks they are the risk takers, but they really can’t handle the volatility.
Having that view of your clients would help immensely in gauging their reactions. And if behavioral analysis is really the way to understand human nature, it may also be the best way for you to serve your clients.