Managing client behaviour to generate higher returns

I’M DELIGHTED that I won the Financial Planner of the Year award. My greatest reward is the reassurance that I provide my clients (and my family) with a fully endorsed and comprehensive wealth-management process that is academically correct and works in the context of their lives.

I believe that one of the reasons I won the competition is that I detailed how I use behavioural finance to make appropriate and meaningful decisions, which also result in better overall investment returns.

Behavioural finance can be used in an efficient and practical manner in the wealth-management process.

GOAL-BASED WEALTH PLANNING

One of the easiest ways to incorporate investor psychology into financial planning is to apply goal-based investing, which involves creating specific goals with defined time horizons and selecting investments with the correct asset allocation for each goal. It works very well for pre-retirement clients who are accumulating wealth, as well as for post-retirement clients who need income from their capital.

Goal-based investing instils excellent budgeting habits and helps people to have a sense of real purpose when investing.

For instance, a relatively young client’s goals could include a holiday in three years’ time, the purchase of a home in five years’ time, and the ability to retire at the age of 55. I’d typically allocate funds for a holiday to low-risk, fixed-interest unit trusts; funds for a house to moderate-risk balanced investments; and funds for his or her retirement to higher-equity and more aggressive investments.

Goal-based wealth management helps investors to focus on the goals and outcomes as opposed to shortterm returns and it provides an intuitive way to talk about investing. It helps to explain risk and asset allocation with regard to attaining their objectives.

Risk profiling is an essential part of this process. It’s easy to calculate the risk required the and risk capacity, but it’s not always straightforward to understand a client’s risk tolerance, which is an emotional factor. This is where behavioural finance comes in.

Questionnaires and software can be helpful, but the problem is that people often don’t understand themselves and fall into the classic trap of recency bias. Simply put, when the markets are positive, they are more inclined to be an aggressive investor, while the opposite is true during times of market pull-backs.

The best way to gauge a client’s risk tolerance is to get to know them, spend time with them, and observe their behaviour as their personal and external factors change.

Although I take my clients’ risk tolerance into consideration, I need to ensure that their risk profiles are correct based on the numbers, including their investment time frame and income requirements. I need to coach and guide my clients if they’re not comfortable with the numbers and the amount of risk the numbers dictate.

UNDERSTANDING INVESTOR BIASES

Another way I use behavioural finance in the wealth-management process is to create an awareness of emotional biases that affect investment decisions. Our brains are hardwired for an “easy understanding” of, and quick solutions, to external factors, but these neural pathways can be entirely counterproductive.

For instance, investors can be affected by loss-aversion bias, which means they feel the sting of losses more than the joy of gains. This can cause reactionary decisions that aren’t good for their long-term goals. Focusing on short-term returns during periods of uncertainty triggers our instinct to make decisions based on fear. I often need to counsel my clients not to sell during bear markets, which locks in losses and creates missed opportunities to benefit when the tide changes.

SCENARIO PLAYING

Scenario playing is also an excellent way to include behavioural finance in the financial planning process.

This is where robo-advice falls short. To date, I have not come across any software that can genuinely integrate all aspects of financial planning – including investing, estate and tax planning – and project the financial outcomes of various life scenarios.

I sometimes assist clients with the decision whether to sell their holiday home, and we discuss the ‘‘with and without” scenarios in detail, including the practical, emotional, financial and tax implications. Selling the holiday home can free up capital for travel and alleviate the cost of maintaining the house and reduce stress. But I also encourage my clients to consider their children, who often can’t afford to travel and rely on the holiday home for their rest. The solution could be to consider asking their children to maintain the house and generate an income by renting it out when the family doesn’t need it.

I frequently discuss the scenarios that will play out when one spouse passes away before the other.

When people are faced with their mortality, they can be very fearful and emotional and avoid discussing the day-to-day financial practicalities that the surviving spouse may have to deal with. For instance, when people are married in community of property and one of the spouses passes away, their joint bank accounts can be frozen, leaving the survivor totally strapped for cash.

I also often discuss the scenario in which a surviving spouse has no insight into their finances and investments, and how I will assist in managing the situation.

CLOSING THE BEHAVIOURAL FINANCE GAP

According to Vanguard founder John Bogle, the average US equity mutual fund gained 173% from 1997 to

2011, but the average equity fund investor earned only 110%. The author Carl Richards refers to this as the behaviour gap, which is caused by investors doing their own thing based on their emotions, typically buying high and selling low. I work with my clients to prevent counterproductive behaviours so that they don’t experience this gap and invest with peace of mind for the long haul.

The current markets are precisely when financial advisers need to stand alongside their clients and wait for the tide to turn. Well-planned and managed portfolios will not be locking in losses right now.

Janet Hugo is a director of Sterling

Private Wealth. A Certified Financial Planner, she is a member of the Financial Planning Institute and is the institute’s Financial Planner of the Year 2018/19.