(Forbes) Investors often spend extensive time and energy analyzing the positions in their portfolios, whether they have selected the holdings themselves or with the assistance of a financial advisor.
While investment research is undoubtedly important, in recent years, economic and investment experts have increasingly stressed the importance of behavioral factors when it comes to successful investment outcomes.
While individual behavioral patterns can complicate an investor’s ability to make sound investment decisions, the situation becomes even more complex when managing wealth in a family setting. The interplay among different family members, their individual investment expectations, and communication relating to those expectations can make the process a challenging one. When significant wealth is involved, the stakes rise, and the challenges can multiply.
The book Preparing Heirs by Roy Williams and Vic Preisser illustrates the difficulties that can arise when managing family wealth. According to the book, just 30% of the families studied were able to successfully transition wealth while keeping it under the beneficiaries’ control, which indicates that focusing solely on investment strategies without taking into account family dynamics isn’t the best approach to managing family wealth.
Even when family dynamics are not an issue, the impact human behavior has on investing success is significant. Humans often make irrational economic decisions.
The Human Factor and Wealth Management
How can you deal with the challenges posed by the human factor when managing your investments, especially when family wealth is involved?
Creating a core set of financial beliefs is crucial to achieving success, as these beliefs guide your approach to investing. Understanding how your financial principles affect your investing results gives you the opportunity to change your approach if your results fall short of expectations.
It’s important to communicate with your spouse in financial matters because it helps you find workable solutions when differences arise about how family finances should be handled. It also helps ensure both parties can manage their finances independently if needed. There is no one-size-fits-all approach to this process, and an approach that works today may not work tomorrow. The key is to make sure the financial strategy you adopt is based upon your financial goals and circumstances and that you understand the reasoning behind the financial moves you’re making.
Prospect Theory and Behavioral Investing
Nobel Prize-winning economist Daniel Kahneman has written about the phenomenon of irrational economic decision-making in the context of prospect theory, which holds that, when it comes to investing, investors often make suboptimal choices.
Some of the cognitive blind spots related to investing that Kahneman and other researchers have covered include:
Anchoring: In investment terms, anchoring refers to focusing on a particular data point when it is no longer relevant. For instance, if you judge a stock’s current price in relation to its high price in the past, you may be fooled into believing that, because the stock is significantly below its high price, the current price represents a bargain. However, if the stock’s prospects have changed dramatically in the meantime, treating the former high as a relevant data point in your decision to buy the stock is likely to be a mistake.
The Gambler’s Fallacy: This is the idea that, after something has occurred more frequently than average, the odds are against it happening again. However, the fact that a coin has landed on heads five times in a row does not mean that the odds of it landing on tails become greater than 50% on the sixth attempt. Thus, betting that a stock will reverse course and either rise or fall just because it has moved in the opposite direction over an extended period of time is an example of the gambler’s fallacy in the investing arena.
Confirmation and Hindsight Biases: Confirmation bias occurs when an investor selectively focuses on research that confirms his or her hypothesis about an investment, rather than treating both positive and negative sources equally. Hindsight bias refers to the tendency to believe that events in the past were easier to predict than they really were. This can make you overconfident about predicting events going forward, while confirmation bias can lead to the trap of making investments based on wishful thinking rather than carefully considered analysis.
Working With a Financial Professional
Given the complexity of modern financial markets and the difficulty investors can experience when navigating them, many work with a financial professional to assist them in this endeavor. Financial professionals offering investment services typically fall into the following two categories: brokers and advisors.
Brokers, also called registered representatives, are not currently held to a fiduciary standard. Instead, they operate under a “suitability” standard, which requires them only to recommend investments that they believe are suitable for a particular client at that moment in time.
Brokers can offer stock in new issues as placement agents.
There is no requirement for full disclosure with regard to multiple fees that may apply.
Brokers act as sales agents for their firms.
In many cases, brokers have selling agreements with particular products due to deals between product vendors and the broker’s parent firm.
When evaluating a broker, their parent firm should be evaluated as well as the custodian the firm uses to hold assets, along with other factors.
Advisors, also known as Investment Advisor Representatives (IARs), are associated with firms licensed as Registered Investment Advisors (RIAs). Both RIA firms and IARs are governed by the Investment Advisors Act of 1940 and have a fiduciary duty to put the best interests of the client before their own.
IARs are paid fees for the advice they provide instead of by the trade, which removes the incentive to “churn” client accounts via individual trades.
IARs don’t sell investment products that pay sales commissions. This provides them with a greater degree of independence than that of traditional brokers.
Assets held by RIA firms are usually housed at third-party custodians, which, as with brokers, should be considered along with the advisor in the evaluation process.
Some advisors are called hybrids. They are IARs, and they have active securities licenses. They can provide financial advice for fees and sell investment products for commissions.
Budgeting and Planning for Time
Whether you are working with a financial professional or going it alone, one crucial aspect of managing your wealth is to always work from a budget. If you don’t know how your money is being spent, you increase the chances of unknowingly spending too much, therefore not saving enough to reach your financial goals.
As you begin building a portfolio, always keep in mind the impact your investment time horizon has on your asset allocation. In general, the younger you are, the more time you have to weather the ups and downs of the stock market. Time has a big impact on your tolerance for risk.
1Preparing Heirs. Roy Williams and Vic Preisser, 2003.