How to save wealthy clients from themselves

Emotion can undo the best-laid financial plans.

Not surprisingly, wealthy investors say that they want help controlling such self-defeating impulses.

They could use the help.

It turns out that wealthy individuals are just as susceptible as the rest of the investing world to buying high and selling low, according to a new study from Barclays Wealth. What's more, they are just as apt to trade too frequently and hurt their overall returns because of it.

Forty-one percent of the more than 2,000 individuals surveyed for the report said that they wish they had more self-control when it comes to their finances.

“There's a strong awareness of their own lack of discipline,” said Greg Davies, head of behavioral finance and quantitative finance at Barclays Wealth. “People are looking for mechanisms to help them achieve more self-control.”

Classical finance theory makes a basic assumption about investors: They behave rationally all the time.

But the panic during the financial crisis is just the latest evidence that that isn't so. However rational and well-thought-out a financial plan might be, it is useless if abandoned when the markets get volatile.

Indeed, studies by Barclays and others show that emotional trading can cost investors up to 20% in returns over the long term. Financial advisers need to do more to help their clients avoid the kinds of emotion-driven mistakes that can sink a solid financial plan, Mr. Davies said.

PRACTICAL ADVICE

“To date, the financial industry hasn't provided much support with this. Telling people they're likely to behave in a certain way isn't enough to get them to change that behavior,” Mr. Davies said.

“Investors need practical things they can do with their portfolios,” he said.

One option is to advise clients to invest in illiquid assets that can't be easily bought and sold.

Mr. Davies likened the approach to Ulysses, who instructed his crew to tie him to the mast so that he wouldn't fall prey to the deadly songs of the Sirens.

But the Barclays' behavioral-finance expert said that such an approach can cause a lot of stress for investors. Instead, Mr. Davies suggests giving advisers greater discretion over a client's assets.

He also advises using hedges or insurance to smoothen the ride, even if a client sacrifices some long-term gain.

“If giving away 1% on returns stops an investor from selling at the bottom of 2008, it's worth it,” Mr. Davies said.

In general, the wealthy investors surveyed for the report are prone to three kinds of behavior that can damage their financial health.

The first is the natural human impulse to buy high and sell low. Another common problem is that investors tend to do too much with too little.

Investors will sit on large sums of cash and then take too much risk, and usually trade far too often with the small amounts they are willing to invest, Mr. Davies said.

“Always do less than you think you should, in terms of trading,” he said.

Finally, investors focus too much on the short term. The psychological impact of investment losses is about twice as much as the pleasure derived from investment gains, Mr. Davies said.

Although there is nothing wrong with worrying about the downside, the bias toward loss aversion can adversely affect decision making, particularly during times of stress.

“We should all be long-term investors, but we have much shorter emotional timelines,” Mr. Davies said.

Barclays Wealth is encouraging its clients to undergo a financial personality assessment that dives deeper into a client's emotional makeup than traditional financial planning does. Based on the results of the assessments, wealth advisers can take practical steps that help their clients avoid some of the damage that irrational behavior can cause.

Mr. Davies said that wealth management firms need to go beyond just training their advisers. They need to build the capabilities into their IT platforms and their product selections, he said.

“The industry is just waking up to the idea that behavioral finance can be practically employed with investors,” Mr. Davies said.

E-mail Andrew Osterland at [email protected].

Related Topics: IN Research, Wealth Management