JP Morgan has invested $30bn in a behavioural finance
framework, showing how investor behaviour theory has moved from an
alternative investment consideration to an integral part of money
managers’ thinking. Maryrose Fison finds it can also provide an
early warning system for market turning points.
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Behavioural economists have earned a reputation over
the years for correctly identifying market bubbles and crashes. In
the late 1990s, Robert Shiller, a respected economist proficient in
the field of behavioural finance, correctly predicted the dotcom
bubble and then the housing bubble a few years later.
Now the theory, which studies the
influence of emotional triggers on the behaviour of investors and
trends in the markets, is gaining credence. Private banks and
wealth managers are taking notice as it influences investment
processes and individual consumer decisions.
JP Morgan’s $30bn
behavioural framework
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By GlobalDataJP Morgan has approximately $30bn
managed within a behavioural finance framework at present and
recently launched portfolios taking advantage of the theory in the
US and Asia to add to its existing portfolios in the UK and
Europe.
James Glover, client portfolio
manager at JP Morgan Asset Management, says the extreme volatility
seen since the onset of the subprime crisis has lent credibility to
behavioural finance-based philosophy in a way that was not apparent
before.
“The chronology of the last two to
three years reads like a taxonomy of the behavioural biases,”
Glover says.
“Greed and hubris on the part of
investment banks, taking on excessive leverage and anchoring bias
as home buyers extrapolated the last few years of house price
appreciation out into the future. [This flowed onto] irrational
fear on the part of investors as the market capitulated in March
2009 before rebounding more than 50% and overconfidence on the part
of central bankers that markets were efficient and would
automatically eliminate imbalances.”
The changing psyche of the
HNW investor
The rising importance of
behavioural investing has been highlighted in the Merrill
Lynch/Capgemini 2010 World Wealth Report. It demonstrates that
emotional factors have become prominent features of the high net
worth individual’s psyche today and firms need to provide offerings
that exploit this.
“Among wealth management firms,
early adopters are incorporating and applying behavioural finance
into their advisory processes to capture and translate investor
behaviour into a more robust advisor process – so as to facilitate
the kind of financial strategies clients really want and need,” the
report says.
Ed Merchant, global head of capital
markets at Capgemini Financial Services, says while behavioural
finance is not a new phenomenon; there is a drastic shift to use
profiling on high net worth individuals (HNWIs) with assets between
$1m to $5m.
Integrating behavioural
finance
A number of firms already
incorporate elements of behavioural finance into offerings for the
ultra-wealthy. Extending these practices to the broader high net
worth population may prove challenging.
Nick Armet, investment commentator
at Fidelity International, says the theory can be applied in
different degrees, with wildly varying outcomes.
“There is a large difference
between the simple process of using behavioural finance theory to
identify the anomalies that are created by the biases of investors
and creating, testing and implementing an investment process that
can exploit them,” Armet adds.
Taking behavioural finance concepts
mainstream could also result in fundamental changes to the wealth
management service delivery model.
Scalability and efficiency across
different wealth bands are likely to be key sticking points and the
process of “operationalising” behavioural finance on a large scale
raises many questions around products, processes, platforms and
service models.
The primary driver for target asset
allocation in the traditional advisory process has been general
risk tolerance. A multi-model asset allocation for addressing
various types of risks and goal orientation would be implemented
under the new, behaviourally-based process.
Forecasting market
changes
Armet points to behavioural finance
as a valuable means of providing early warning signs for market
turning points as well as transforming the investment process for
the client.
“The basic emotional triggers that
drive investors are fear and greed with almost everything else
being some variation of these two primitive instincts,” he
says.
“These two emotional responses are
perhaps most apparent at turning points in stock markets. Investors
get overly confident as markets move up steeply but become fearful
when they fall sharply. This fact, in itself, is useful for judging
turning points because we can use mutual fund sales and redemptions
as a gauge of investor sentiment.”
Not a solution on its
own
Money managers warn against letting
behavioural finance overtake conventional economic theories in
spite of its popularity.
“Behavioural finance is not
designed to replace conventional economics; it merely seeks to fill
in some of the gaps,” says Armet. “Investors should not see
conventional economics and behavioural finance as a choice but
rather as an enlarged and mostly complementary body of knowledge
with which to make sense of markets.”
The worst of the global financial
crisis may have passed, but Armet believes its rapid move into
mainstream thinking will prevail.
“Market cycles seem to have become
shorter and more pronounced over the last decade or so which raises
the importance of behavioural finance in explaining the prevailing
investor psychology,” he says.
“The investors who understand behavioural finance best and are
able to guard against their emotions and human biases, stand to be
most successful in this kind of market environment,” Armet
concludes.
