Although the concepts of behavioral finance have been used by money managers for more than a decade and a half, there have been few efforts to employ them to help individual investors make intelligent choices for their portfolios. But in 2006, Barclays Wealth, the wealth management division of Barclays Bank, assembled a team of experts with degrees in behavioral finance, experimental psychology and decision science to do just that. The program was rolled out to clients two years later and now helps shape the investment decisions of about 5,000 high-net-worth clients in Europe, the Middle East, Asia and the U.S.
Greg Davies, head of behavioral finance for Barclays in London, says the goal of his team is to go further than the classic risk-return trade-off offered by normal money managers. According to Davies, who holds a Ph.D. in behavioral decision theory from the University of Cambridge, while many investment advisers focus only on the long term, his team is equally concerned with the process that it takes to reach long-term goals.
“In classical finance the journey is considered to be irrelevant, but the fact is, it is not irrelevant,” Davies says. “I could put you in the most perfect portfolio, but if in a few months’ time you get too nervous to stick with it and sell out of it, I haven’t helped you at all.”
Davies’s team developed a 36-question psychometric profile that allows Barclays to get a more complete picture of its clients. In addition to the traditional measures of risk tolerance, the questionnaire helps the firm gauge composure (how an investor reacts to uncertainty in financial markets), market engagement (how comfortable an investor is with financial market risk) and perceived financial expertise (how much familiarity the investor has with markets).
Davies explains that two investors might have similar risk tolerances but different levels of composure, which means one worries about short-term ups and downs and the other doesn’t. The high-composure individual will be given a simple portfolio that conforms to his risk profile and investment horizon.
The low-composure investor is likely to get excited at the highs and start doubling up on risk, and become overly fearful at the bottom and sell out. For this individual, Barclays designs a portfolio that doesn’t scale back risk but invests in products that smooth out market gyrations.
Davies calls his approach the “nicotine patch” of the financial world. As smokers know, the rational thing to do is quit, but it’s hard to go cold turkey. So they do something slightly irrational — they spend $20 to $30 a week on nicotine patches, to achieve a better outcome in the end.
“You don’t need a comprehensive model of human behavior to be able to make these valuable, data-driven, objective assessments of what is good or bad for specific investors,” Davies says.
