Behavioral finance has been a part of the curriculum for the CFP®, CFA and CIMA designations for many years yet has received limited attention in terms of its direct application to the investment decision process. This is surprising given the general acceptance that markets are driven, at least in the short and medium term, by behavioral factors. For example, if you consider the price action of Apple stock over the past year, the financial crisis of 2008 or the technology bubble/burst in 1999/2000, it’s easy to see that markets systematically (and predictably) overshoot and undershoot their fair values based on sentiment. These departures from fair value are precipitated (and exacerbated) by investor misjudgments about the future which lead to poor entry/exit decisions into both managers and asset classes. Evidence from Morningstar, among others, confirms that investors systematically buy funds after periods of outperformance and shun funds that have experienced bouts of underperformance. Repeated often enough, these decision errors can permanently alter the return trajectory of client portfolios, leading to both poor relative returns and poor risk-adjusted returns over longer periods.

Strengthening the investment decision process

It would seem both logical and practical that advisors can add significant ‘alpha’ to portfolios by 1) minimizing client behavioral mistakes and 2) devising strategies to profit from the behavioral mistakes of others. For example, the IPS can be tailored to structurally profit from mean reversion by strategically adapting beta exposures within a wider allocation range versus mechanically re-balancing portfolios to a static number on a calendar year basis. This has the potential to condition the client to view significant market drawdowns as buying opportunities and increase their allocations to beta when the expected future return is highest. In terms of manager selection, there is strong evidence that manager rankings are mean-reverting, suggesting a healthy dose of luck when manager results are at their highest. In fact, the most recent S&P Persistence Scorecard shows roughly equal odds of landing in the top quartile over the past 5 years whether you started in the 1st, 2nd, 3rd or 4th quartile at the beginning (all domestic funds). For small caps, you were better off picking managers in the bottom half if you wanted to end up in the top half. This would suggest 2 or 3-star funds should not be summarily dismissed from consideration. Yet, year in and year out, greater than 100% of net flows go into funds rated 4 or 5 stars by Morningstar (star-rated funds).

Armed with this knowledge, advisors who seek ways to tighten-up their investment decision process, including incorporating best practices from the fiduciary world and behavioral finance, will be in a better position to capture assets and add advisor ‘alpha’. Given the heightened regulatory focus, this is a meaningful opportunity to differentiate one’s practice as it is highly unlikely that those moving to robo-type advice will be in the same position to deliver this form of ‘alpha’ to their customers.

Excerpts from Decision Economics, Applying Behavioral Finance to Improve Decision Making, a professional development program for advisors offered in partnership with Greene Consulting.