There is much that is right about the traditional financial models – the result of decades of research, discussion, and debate – but they are only completely right for the hyper-rational investor, the so-called Homo economicus (an ideal investor who simply doesn’t exist).
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It assumes that once an individual has agreed upon an optimum investment solution, they not only can implement it, but they can also persevere with their strategy over long periods of time, making rational adjustments regardless of what they have to endure along the way. It also assumes that all investors care about is risk adjusted returns. They don’t. What investors really want is the best returns they can achieve for the level of stress they’re going to have to experience. Some of this stress does come from taking risk, but a great deal of anxiety arises from emotional responses to fluctuations along the investment journey, which are quite independent of risk. As a result, what investors truly want is, what we at Barclays call, ‘anxiety-adjusted returns’: the best possible returns, relative to the anxiety, discomfort and stress they’re going to have to endure over the volatile investment journey.
But to throw away decades of research on the grounds that the models invoke some simplifying assumptions is to throw the baby out with the bath water. We believe the conflict between behavioural and classical finance is misplaced. There are aspects of the classical investment model that have served us well.
Therefore, at Barclays, we have taken the best of classical finance and sought to behaviouralise it. This may sound strange but by focussing on something other than long-run financial efficiency, we are actually able to get closer to it. The answer to this seeming paradox is to realise that, without looking after our short-term need for emotional comfort, we may find it very difficult to enact and stick with the ‘right’ solution; ultimately, these investors will aim for perfection, but fail, and fail expensively. As investors, we devote some portion of every decision to securing the short-term emotional security that we crave, and which makes the pursuit of the longer-term objectives possible … but at a cost to the perfectly efficient long-term investment choices.
Classical finance’s response to this problem is to label it ‘irrational’ and ignore it. At Barclays, we acknowledge that the need for comfort is not going away – after all, it is what makes us human. Instead, we seek to provide this comfort in targeted, efficient and planned ways, rather than via the unplanned and expensive methods investors employ with knee-jerk responses along the journey.
“at Barclays, we have taken the best of classical finance and sought to behaviouralise it”
Our approach to behavioural finance allows us to pinpoint in advance which investors are most likely to harm their long-term returns through this behaviour, and in what ways. We don’t just tell stories or spin anecdotes. Instead, we use our proprietary Financial Personality Assessment™ to measure six stable personality attributes that distinguish one investor from another.
These six dimensions allow us to tailor the advice we give to each investor to provide them with not only a sound long-term solution, but one that helps them better manage and control their investment decisions along the way. This may mean slightly side-stepping the classical solution, and purchasing the emotional comfort that all investors require. But when these deviations are targeted to the personality of the individual, they enable the investor to achieve a better result in practice.
Later in this paper, we will discuss how we use our investment philosophy (a combination of emotional and scientific dimensions) and the following categories of tools to tailor client solutions:
- Risk targeting
- Trading off efficiency for comfort
- Management style
- Investment frameworks.
These tools are specifically designed to help investors navigate their way through the so-called zone of anxiety – the point at which most investment losses occur. If we are to turn this knowledge into practical, useful advice, we need to be able to reliably identify, in advance, which investors are naturally prone to seek emotional comfort in particular ways, and when.