Avoiding the Siren Song of Emotions: Notes from the Wealth Management Conference
What do Homer’s Odyssey, Boombustology, and “financialese” have to do with wealth management? Quite a lot, it turns out.
Let’s start with the Odyssey. In his presentation on utilizing behavioral finance in the management of client portfolios at the CFA Institute Wealth Management 2012 conference, Greg B. Davies, global head of behavioral and quantitative investment philosophy at Barclays Wealth, explored the concept of what he called “behavioralizing finance.”
“This is not behavioral finance versus classical finance,” he said. “We don’t believe that classical finance is something that should be thrown away. What we believe is that classical finance has not gone far enough; it has not considered what it truly means to be human. It has not considered certain aspects of our intuitive responses to the investment journey in order to make us better investors.”
Davies argued that there is a fundamental disconnect between helping clients invest for the long term and the fact that we live perpetually in the short term, or what he called “the zone of anxiety,” where we are buffeted financially and emotionally by uncertainty. (See “What Should I Do? Translating Long-Term Trends into Action” published in Compass in October 2011.)
Behavioral finance, he told attendees, “recognizes that decisions are always made in the zone of anxiety, but the end goal is always long term and what we have to do is help the decision maker attain that end goal.” One way to do that is to purchase emotional comfort — even if it comes at a cost. (This is further explained in a recent book Davies coauthored with Arnaud de Servigny titled Behavioral Investment Management: An Efficient Alternative to Modern Portfolio. “Successfully implementing one’s optimal portfolio requires emotional comfort and shying away from risky assets and sitting on cash is one way of acquiring this comfort,” they write. “However . . . it can be a very expensive way of doing so because it means that your portfolio will have dramatically lower risk and return than is optimal.”)
Davies pointed out that there are two systems of reasoning, intuitive and deliberative, and that for most decisions the two are very closely aligned. When it comes to financial decisions, however, they become very misaligned. “Our objectives can be 15 years out, and yet our emotional selves are making decisions now, in the zone of anxiety”.
Enter the Greek hero Odysseus (or Ulysses, as he was known in Roman myths), who is heading home after the fall of Troy when he sails past the island of the sirens (dangerous creatures, portrayed as seductresses who lured nearby sailors with their enchanting voices to shipwreck on the rocky coast of their island).
The rational solution would have been to bypass the island. But Ulysses had his crew bind him to the mast and stop up their ears with beeswax. In so doing, he was taking steps to constrain his future behavior. “He knew that he was human, fallible, and that he was likely to succumb to temptation,” Davies said. Likewise in investing, there are times when our best intentions will be insufficient to overcome the force of our short-term desires.
For more on averting sirens, read Davies’ interview with City A.M., “Blocking Out the Sirens’ Call: How to Protect your Wealth from Emotion.” And to hear how behavioral finance can be applied to your clients’ portfolios, click here to view the webcast from the conference.
In a riveting session, “Boombustology in Action: The Case for a Chinese Investment Bust”, Yale lecturer Vikram Mansharamani said there are two types of problems in the world, or two extremes: puzzles (which are clearly defined, have “answers,” and are best solved by acquiring more data) and mysteries (which are poorly defined, ambiguous, uncertain, probabilistic, and without answers). With mysteries, the best we can hope for is to understand various scenarios and to play out the probabilities and ramifications of each of the scenarios. And the way to do that is to use multiple lenses to form connections between existing data. In other words, to connect the dots.
Mansharamani then offered five lenses for identifying “the mysteries of bubbles” — microeconomics, macroeconomics (specifically credit), psychology (hubris, overconfidence, “this time it’s different”), politics, and biology — along with some fun indicators, including skyscrapers, art markets, magazine covers, and TV shows. And then he asked: Is China next?
- Clue Number One: Skyscrapers as a bubble indicator: 5 of the world’s 10 largest buildings now under construction are in China.
- Clue Number Two: Chinese Vase Zooms From $800 to $18 Million in Record N.Y. Sale and £1 Million for “World’s Most Expensive Dog”.
If the answer is yes, what then? Mansharamani stuck his neck out and forecast that over the next decade China would grow at no more than a 4% CAGR.
If you’d like to know more, look for an upcoming post by Charlie Henneman, CFA, about Mansharamani’s keynote presentation.
Over the years a lot has been said about goals-based investing, but as Jean L. P. Brunel, chief investment officer at GenSpring Family Offices, told conference attendees, after a “fairly long somewhat painful challenging birth, it has now become something that is being used.”
Brunel said it was crucial to recognize that goals-based wealth management is not limited to the investment side.
“That is a very important element, because the fundamental need of our families is not just to have their assets managed,” Brunel explained. “If that is what they had, life would be very simple, but they have a whole bunch of other goals. They have goals that relate to their estate planning (that is more true obviously in the U.S. and Europe than it would be Asia, because in many countries of Asia there is no such thing as an estate tax, so from that point of view gifting money from one generation to the other is somewhat simpler), but they also have philanthropic issues, they have investment issues, and as a result you throw into the mix something that makes life quite complicated, which is asset allocation.”
He also suggested changing the terminology that advisers use with clients. “If you ask me what my return expectations are or how I define my risk, I am going to be stumped,” he said. “However, you start talking to me about nightmares as a proxy for what I view as risk, then it becomes a lot easier for me to tell you what I am fearful about. And it even becomes easier for me to organize and order my fears. Virtually every family I have worked with has told me that their worst nightmare is to change their lifestyle.”
Brunel said using dreams and nightmares as a way of replacing return and risk “is an important [strategy] because it involves in effect getting closer and closer to what the client is actually thinking.”
Clients “describe nightmares and dreams and then ask us: Can you create a portfolio that will make it work in the financial markets?” Brunel said. Clients express their goals in their own language — “they don’t speak ‘financialese”’ — and it is the job of the adviser to translates them into financial and investment language.
When it comes to identifying goals, he said, they generally fall into three categories: the personal (“I have wealth because I want to do a certain number of things for myself”), dynastic (“My money is for my children”), and philanthropic (“Think Warren Buffet, Bill Gates, Chuck Feeney”). The challenge is that there are also different levels of risk (or risk profiles) associated with each of these goals.
Brunel said that before joining GenSpring he approached goals-based wealth management thus:
- Describe the goals of the investors.
- Dollar weigh and prioritize the goals.
- Structure a subportfolio (first identify the eligibility of certain assets classes, and then combine them in some sort of sensible portfolio).
- Optimize portfolios across the whole family.
That was fine when he was working with 14 clients — but with 650 families at GenSpring, it proved impossible to customize. So he came up with the idea of mass customization: “The notion is to start thinking in terms of generic goals and generic portfolio models to defease that goal, and then mass customize these modules into a portfolio that is only relevant to one person.”
To hear more from Brunel, click here to view a recent webcast where he explains goal-based allocation in addition to exploring a sequential approach to setting goals, the skills necessary to identify and quantify assets in each sub-portfolio, and ways to implement goal-based allocation in your practice.
For more conference coverage, read the post from Stephen Horan, head of university relations and private wealth, on Paul Bouchey’s session on volatility harvesting.
The 2016 CFA Institute Wealth Management Conference will be held in Minneapolis, Minnesota, 16–17 March 2016.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.