Changing investors’ behaviour for the better requires practical actions that have tangible results. This requires understanding our emotional needs, and our behavioural proclivities.
Residents of the United States, please read this important information before proceeding
Each investor will bear the behavioural costs to long-term performance outlined in ‘Cycle of investor emotions’ to different degrees.
- Some will have greater natural reluctance to enter the markets, some less
- Some will have a greater need for familiarity
- Some will need to be confident that the worst case is limited
- Some will find it difficult to stick with a volatile portfolio
- Some will be nervous if they don’t retain control of the investment decisions
- Finally, there are the rare individuals who know about all these failings and yet are able to control them with apparent ease
Most of us need some assistance in attaining comfort as cheaply as possible.
Changing investors’ behaviour for the better requires practical actions that have tangible results. This requires understanding our emotional needs, and our behavioural proclivities. Only when we have an objective understanding of what makes one investor respond differently over a market cycle from another, and how their needs for short-term comfort differ, are we in a position to make bespoke changes to their portfolio solutions that provide the necessary short-term comfort intentionally, directly and efficiently. This is the cornerstone of our use of behavioural finance at Barclays: to use our knowledge of investor psychology to make targeted and implementable changes to actual portfolios that most cheaply provide the emotional insurance investors require, thus improving both their eventual returns, and their satisfaction.
But to do so we need an accurate means of identifying the ways in which they are likely to reduce their own returns in the quest for short-term comfort, and we use our proprietary Financial Personality Assessment™ to help with this. This marks a substantial shift away from the traditional approach to investment portfolio design, which focuses almost entirely on the investor’s tolerance for risk and ignores other, equally important, factors that were difficult to assess.
The Financial Personality Assessment™ (FPA) is a proprietary research survey that measures six different aspects of an individual’s personality, each of which relates to their financial behaviour and decision-making. It was developed to paint a more complete portrait of each investor’s inherent responses to financial decision making, which in turn enables us to develop more effective individual investment solutions. These solutions are deeply tailored, taking into account the vagaries of the investment journey, and thus can provide a better return. In essence, the FPA helps us to determine which emotional needs are most important to each client, and to identify which costs they are most in danger of incurring. We can only help investors get closer to their long-term financial objectives if we understand these factors at the beginning of the investment process, before they enter the market.
We developed and calibrated the Financial Personality Assessment™ tool using data from over 3,000 individuals worldwide and tested hundreds of questions before arriving at the final set. These questions have been selected using strict principles based on scientific evidence of what works and what doesn’t in eliciting personality traits. For example, to be useful to guide investment recommendations, we want the scales to be reflective of stable, underlying psychological responses to risk and uncertainty over the investment journey. We don’t want them to be a test of intelligence, investment knowledge, education or numeracy. For this reason, none of the questions require knowledge of finance, and none require calculation or probabilistic reasoning.12 Also, because we want the scales to reflect investors’ proclivities throughout the cycle, and not just their current emotional response to the market environment, none of the questions refer to current economic conditions, or
require predictions or future asset returns.13
Since launching our Financial Personality Assessment™ in 2007, we have deployed it around the globe and it is key to how we advise high net worth individuals. This period has been one of the most turbulent periods in living memory for investors, and has provided an extreme testing ground for observing investor behaviour and, crucially, for stress testing our tools and framework. Though we have made tweaks to the questionnaire as a result of our continued testing, analysis, and experience, the dimensions have proved to do what they were designed to do: provide stable and objective assessments of financial personality traits, even in extreme environments.
Describing financial personality
Figure 7 illustrates the difference between the profiling approach of traditional finance, and our Financial Personality Assessment™. The traditional industry approach measures only the investor’s long-term financial willingness to trade off risk and return, and largely proceeds on the basis that this is the only valid objective for an investor to have. Our approach still places Risk Tolerance at the heart – after all, long-term financial performance is what investing is essentially about – but we also measure five other aspects of financial personality that enable us to help an investor get as close to the long-term optimum as possible.
Figure 7: Know thyself – Financial Personality Assessment™
Of six dimensions measured by our Financial Personality Assessment™, three explore risk attitude (something academics have known for decades can’t be understood as a single concept), and three relate to the investor’s decision style.
It is these dimensions that most strongly reflect the proclivities for investors to seek emotional comfort along the investment journey, and allow us to optimally purchase emotional comfort.
Risk Tolerance is an expression of the long-term financial objectives that classical finance, and the majority of the financial services industry, considers to be the only objective investors either do, or should, entertain. Risk Tolerance helps to determine which combination of asset classes is optimal to attain the highest expected returns for the level of risk that the investor is prepared to take on. Measuring Risk Tolerance, however, is where many of our peers stop. For us, it is merely the start.
Composure describes an investor’s degree of emotional engagement with the short term, and the degree to which emotional responses in the zone of anxiety may come to dominate long-term financial objectives. Investors with a high level of Composure are relatively unaffected by the temporary ups and down of the market, and can keep their focus firmly on the longer term. They are less likely to over-respond to events, and less prone to buying high and selling low.
All investors, however, need some emotional security – just some less than others. High Composure doesn’t mean that one is immune to the temptations of security in the short term. When markets are turbulent, or in crisis, even the most composed individual can feel discomfort and run out of emotional liquidity.
The high Composure investor tends to pay too little attention to market movements, and may not change their holdings to react to those changes. They may fail to rebalance effectively, and may well be in a portfolio that is an unconnected clutter of individual assets acquired over the years, with no assurance that these function together as an efficient whole. One solution for such an investor is to hand over the portfolio to a discretionary manager: you pay for the management but this can often be substantially cheaper than the forgone upside of a poorly constructed portfolio. However, this is only a solution if the investor is also comfortable with such a high level of Delegation – one of the other personality dimensions.
For a low Composure investor, lack of involvement is less likely to be a problem – they may be all too engaged, but their reservoir of emotional liquidity may deplete faster than others’ in response to bad times. Their anxiety levels are likely to be higher for any given level of risk or volatility. To acquire the comfort they need to cope with such intense involvement with the short term, they are likely to be tempted to buy high and sell low.
“Once you exit the market for emotional reasons, you can’t quickly and easily get back to optimism, but have to gradually claw your way back through despondency, depression, apathy, indifference … and reluctance. This can take many years”
The third risk attitude dimension is closely related to our baseline levels of reluctance. It refers to our ability and willingness to enter the markets in the first place.
Low Market Engagement can also lead to inefficiency through what we invest in, as such investors source the comfort they need to invest by costly actions such as:
- Concentrating the portfolio in assets that feel familiar (familiarity bias)
- Phasing investments in only gradually (e.g., dollar cost averaging)
- Giving up the premium they could earn from accepting lower liquidity, even when they don’t need high levels of liquidity
- Excess belief in convincing investment stories
- Paying for short-term protection in order to attain the comfort to get in
As long as these costs are less than the 4–5% per year the investor would on average receive from an efficient14 moderate risk investment portfolio, the investor is still better off. However, there may well be more efficient ways of buying that comfort.
High scores on Market Engagement are not always benign either, and may indicate a little too much readiness to invest. ‘Cocktail party’ investing occurs when the investor has high Market Engagement, and is too keen to take part. Such investors often respond too enthusiastically to tips, buying because those around them are doing so rather than on the basis of risk and return. Frequently, such tendencies result in portfolios that are insufficiently diversified and, in particular, are over-concentrated in investments which have a good narrative, or are well publicised. All too often those investments with the most-engaging stories are those that have done well in the recent past, leading investors to buy high, and chase past performance.
The next three dimensions identify the tools that are most appropriate for each portfolio based on the investment style most suitable to the client.
Perceived Financial Expertise
This is a measure of investors’ degree of comfort with, and confidence in, their own ability to make good financial decisions. Investors with a high rating on this scale will be more comfortable making complex choices, considering more information, and weighing the options. Investors low on this scale will prefer simple solutions with clear reasons for why these are suitable, rather than having to weigh the pros and cons of many options. They will also feel more comfortable with their portfolio if the advisor has taken the effort to ensure they have provided adequate explanations and information or financial education at the appropriate level. They may also be more prone to all the needs for comfort outlined above due to nervousness, and lack of certainty of the right approach, exacerbating inaction or inertia, depending on the rest of their personality makeup. However, overconfidence can be just as dangerous when coupled with the short-term focus of low Composure, or the trigger-happy nature of high Market Engagement.
Some investors are happy to delegate management of their portfolios, reducing anxiety by sharing or outsourcing the emotional burden of decision making, while others are only comfortable if they retain close control themselves. For those with high Delegation scores, handing over the decision making to a professional manager can be a very good solution. However, the important observation is that these personality dimensions interact with each other in some subtle ways. For example, a discretionary portfolio can help the high Composure investor overcome inaction or apathy, and can do the same for a nervous investor who has low Perceived Financial Expertise. On the other hand, the greater emotional distance from the portfolio movements, decisions, and details that come with Delegation can also be useful in eliminating the short-term stress of a low Composure investor. For those with a low desire for Delegation, the solutions need to come from elsewhere, and be more direct.
Belief in Skill
The Belief in Skill section of the analysis looks at the degree to which the investor is innately comfortable with paying for potential outperformance of the market. Those with high scores will want to seek out skilled managers who will achieve higher returns. They are also likely to be more comfortable with stronger tactical shifts in the portfolio to take advantage of medium-term opportunities afforded by the changing environment.
Those who are low on the scale are likely to be uncomfortable with any such efforts, and are certainly more reluctant to pay a premium for them. They typically prefer low-cost index funds, and stable asset allocations.