How to Use Behavioral Finance in Asset Management, Part I

Over the decades, I have consumed the entire canon of Behavioral Finance, from Ariely to Kahneman to Thaler to Shiller and back. The academic research on the topic is relevant, robust, and utterly fascinating. It continues to become more influential with each passing day.

What I have seen much less of are the ways to implement the lessons learned about human psychology in the day-to-day aspects of managing money for clients in an wealth management firm. I don’t mean theoretically, but the actual block & tackling, day-to-day work of running a money management firm. If you work in money management, then a part of your job will involve some aspects of branding, finding clients, running their money, managing their expectations, communicating with them on a regular basis, reporting performance, building a set of goals, etc. In all of these areas, the knowledge accumulated from behavioral finance can be enormously helpful.

And yet, there is little in the way of advice along those lines.

I believe this is a huge oversight.

More than understanding the basic concepts, how can a practitioner take what we know about the ways cognitive errors impacts investors, and use these to design the fundamental building blocks of a wealth management firm?

Its a worthwhile question. This week, I hope to answer it, rectifying an oversight by getting very specific and granular about how to apply behavioral economics across three different groups of people:

Us (as practitioners)

Our Clients (as investors)

The Public (as investors and potential clients)

These are what I believe to be best practices for using Behavioral Economics within a Registered Investment Advisory (RIA) firm — primarily across these three specific constituencies. In particular, we want to consider the a) decision-making process; b) the data set of information influencing people; and c) how to manage emotions across a variety of market conditions.

From narrowest to broadest, let’s jump right in.

Us: Research & Analysis

I believe we as asset managers have an obligation to put into practice what we know about human cognition and psychology in our everyday work.

Thus, we begin by trying to lead by example. Several of the ways we do that is through enlightened self-awareness, and by showing the process behind our thinking. By that, I refer to: a) writing in public; b) explaining our thinking process; c) being pro-active about admitting and embracing errors; d) debunking nonsense in the media and online (especially issues identified by clients); e) recognizing our own cognitive biases, and taking concrete steps to avoid or at least minimize them. My unsubstantiated belief is that any asset managers who do this will be at a strategic advantage over those who do not.

Let’s look at just a few of the things we do to try to practice what we preach:

1. Analyze & write in public: We begin with our simple approach of being very public in all of our writing and analysis. This includes all of the firm’s various writers: Me, Josh, Mike, Ben, Tony, Blair and Nick. Not only do we write in public, but we maintain a permanent archive of all prior writings.

I believe there are many benefits of sharing our thinking in a very public format, but let’s just focus on these three:

  1. We create a track record of our views, thereby avoiding hindsight bias;
  2. We are intellectually harmonious in our commentary, maintaining a philosophy that is both recognizable and consistent;
  3. Spurious and/or reckless commentary is immediately called out; we hold ourselves accountable for what we write when speaking to the broad investing public.

More than just creating a recognizable investing philosophy, all three of these hold ourselves out to the public as accountable. There is an ugly sub-genre of reckless and irresponsible fear-mongering, along with its greed-based corollary. Both tend to be short-term, as this hot button approach is unsustainable over longer periods of time.

By being so very public in our writings over longer periods of time, we want to create the standard for measured, responsible market commentary.

2. Positive and Negative Weekly Summations: Each week, with the help of our staff, I post at TBP a succinct summation of the week’s events. The caveat is that it must contain a balance of positive and negative bullet points from the world of economics, corporate news, markets, and geopolitics.

This intellectual process forces you out of whatever market modality you are in: You cannot be a rampaging bull when you are assembling a list of negatives every week; nor can you be a full-on bear when the news flow has so much positivity in it. It also avoids allowing your own confirmation bias to creep into your view of the world.

It is harder than you might imagine.

3. Annual Mea Culpas: I learned this from Ray Dalio about a decade ago: every year I make a list of what I got wrong and what I learned from the experience.

I find doing this is incredibly freeing. You begin to realize that errors are common place, to be embraced, not hidden away. Second, acknowledging your mistakes is a great way to learn from them. Last, you get out of the headspace of the resulting business and into the mindset of a process business. It’s a huge strategic advantage to understanding the difference between the two.

4. Counterfactuals / inversions: Finally, pulling a page from Charlie Munger at Berkshire Hathaway, we have all taught ourselves to invert. The counter-factual way of thinking avoids a variety of heuristic and psychological errors. It helps with debunking nonsense. It allows us to recognize how the element of chance and randomness plays into large complex systems like the economy and markets; it helps you to consider possible alternative outcomes to different situations. In terms of managing risk, it lets you consider extreme or unusual possibilities that might never have entered your mind without the counter-factual.



Coming tomorrow in Part II: How Behavioral Finance can help with clients


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