mature couple with young financial advisor

Financial advisors increasingly are turning to behavioural finance to coach their clients, and portfolio managers are leveraging the concept to profit from others’ blind spots – especially given stock markets’ volatile ending to 2018 and mounting concerns about a bear market and economic recession coming in 2019.

Behavioural finance challenges traditional assumptions about rational economic behaviour and identifies biases and the role of emotions in decision-making. As the field becomes more mainstream, firms are applying tools to measure risk and engage clients, as well as to check on portfolio managers’ decisions.

“The biggest risk to [clients’] retirement plans is [clients themselves], in the sense that investors often end up investing with their emotions instead of investing with logic,” says Jean-François Démoré, president and certified financial planner with Innova Wealth Builders (a unit of Aligned Capital Partners Inc.) in Sudbury, Ont. “Any tool you can use to help eliminate those mistakes is a good investment.”

Démoré has spent much of the past year addressing “recency bias” with his clients. After a record-long bull run, clients have begun to expect markets to only go up. “Clients forget what it’s like to lose money,” he says.

Démoré, who has a computer science degree, developed a tool that allows him to run portfolios through various market simulations, both real and hypothetical. He shows his clients how their investments would have fared in October 2008, for example, or what would happen if the Canadian real estate market were to crash.

The simulations allow Démoré to address common blind spots – namely, that clients think they’re more comfortable with risk than they really are. Says Démoré: “You can have a conversation with a client and both [of you] agree that [he or she is] medium risk, but that can mean two different things.”

Another potentially damaging blind spot among investors when markets take a downturn is loss aversion, says Lisa Kramer, professor of finance with both the Rotman School of Management and the department of management at the University of Toronto proper. She notes that psychologists Daniel Kahneman and Amos Tversky performed experiments that showed that the pain associated with losses has twice the impact of the pleasure from gains.

“Just the possibility that the market might go down even more sometimes causes people to sell their stocks pre-emptively” – no doubt against their advisor’s advice, Kramer says.

TD Wealth Private Wealth Management, a unit of Toronto- Dominion Bank, also is focusing on technology with its TD Discovery Tool to help clients get a better handle on their emotions. Launched in April 2017, the tool aims to help the firm’s high net-worth (HNW) clients understand their own tendencies and enable advisors to work with these clients better, says Dave Kelly, senior vice president with TD Wealth Private Wealth Management.

“Understanding [clients’] decision-making process is integral to making sure we’re keeping them invested when they should be and helping them not be invested when they shouldn’t be,” Kelly says.

The TD Discovery Tool has clients rate the accuracy of 50 short statements that cover everything from the richness of their vocabulary and the speed at which they complete chores to their comfort with strangers. “[These] really broad, thematic questions [help us] try to get a sense of how [clients] make decisions,” Kelly says.

The tool then produces a “wealth personality report” that reflects clients’ specific traits, such as spontaneity, self- discipline and amenability. The report also lists investing “blind spots” that could lead to poor decisions, such as being paralyzed by too many choices or focusing on short-term benefits.

Although there’s no “magical elixir” for helping clients deal with events such as the market turmoil that took place at the end of 2018, there are steps you can take to prepare your clients for these events, says Kelly: “If I were an advisor, I would want to have had this conversation with my clients before [stock markets declined], if at all possible. [Our tool] gives the advisor insight into what the client is maybe thinking and feeling.”

Roughly 10,000 of TD Wealth’s HNW clients have used the tool, and although some advisors initially were reluctant to embrace it, they’ve come around, Kelly says: “I always say the toughest thing is for advisors to bring something new into their relationships with clients.”

The next step is to get more of the firm’s clients using the tool. To that end, TD Wealth will be rolling it out this year to the firm’s financial planning division, which serves clients who have $100,000-$1 million in investible assets.

Not only are advisors embracing behavioural finance, but portfolio managers also are looking at it more closely. For example, portfolio managers at Richardson GMP Ltd. in Toronto have added behavioural finance-related questions to their buy and sell due-diligence checklist, says Craig Basinger, chief investment officer and portfolio manager at the firm.

The questions address confirmation bias (“Have you sought and considered contrary opinions?”); recency bias (“How important is recent price performance to your decision?”); availability bias (“Is recent news swaying your decision?”); and anchoring (“Do you have a previous high or an initial purchase price as an anchor?”), among other questions.

Basinger also is portfolio manager for Toronto-based Purpose Investments Inc.’s Purpose Behavioural Opportunities Fund, which seeks to profit from irrational investor behaviour.

“This is the weaponized version [of behavioural finance],” Basinger says of the fund, which launched in late 2017. “We’re going to try to educate you so you avoid as many of these mistakes as possible. But, at the same time, we’re going to try to make money off people who are making emotional mistakes.”

The Purpose fund targets availability bias and recency bias in overreactions to corporate earnings, which take place when a positive or negative surprise sparks a dramatic move in a stock’s price. This happens because investors tend to overweight the most available news, Basinger says.

The price moves most often are short-lived, creating an opportunity. A high-quality company that narrowly misses its earnings target can see a material drop in its share price, creating buying opportunities. Lower-quality companies that surprise on the upside, on the other hand, tend to “bleed those [short-term gains] out really quickly,” Basinger says, creating short-selling opportunities.

The Purpose fund also seeks to profit from “herd mentality,” which occurs when investors feel safer about holding a stock that has many “buy” recommendations. This means potential gains are usually priced in, Basinger says.

“We found that when analyst recommendations [are made],” he says, “the companies with fewer ‘buy’ recommendations tend to perform better.”