A fusion of goals and behavior
The gist of behavioral finance is that investors can be their own worst enemies. It doesn’t matter how solid a particular investment or set of investments is if an investor is going to consistently undermine their own chances for success through poor decision making, panicking or overreacting. At Fusion, we are well versed in both the principles of modern finance (Modern Portfolio Theory) and the principles of behavioral finance or as we call it, PsyFi™. We firmly believe that the highest likelihood of developing and maintaining custom-tailored solutions designed to optimize each client’s probability of achieving investment success is through fusing these two financial theories. To that end, we are proud to offer our clients advice based on the most current state-of-the-art advisory principles available: our PsyFi™ approach.
BACKGROUND ON MODERN AND POST-MODERN PORTFOLIO THEORY
The principles of modern finance focus on statistical relationships of risk and reward across countless available investment options; variables like Standard Deviation, Sharpe Ratio, Alpha, Beta, R-Squared and 10-year Returns are generally the main focus. What’s critical to the effectiveness of modern financial theories is the assumption that most investors take a rational approach to seeking wealth enhancement. That’s rarely the case. We believe that the probability of success for investors would increase dramatically if there was a published track record of their long-term financial behavior that we could use in establishing their custom-tailored investment plan. An updated study by Dalbar revealed that while the S&P 500 provided annualized returns of approximately 8.2% per year for the 20-year period ending in 2012, the average investor in stock funds returned just over 4% per year – almost 50% less annually – for the same 20-year period. This dramatic underperformance can be mitigated substantially by identifying and addressing the behavioral finance-related errors responsible for this performance gap. Advisors whose advice relies solely on principles of modern finance are likely ill-equipped to help clients avoid the most important and common mistakes, the ones that so often derail investor’s ability to maintain a well-thought-out and disciplined approach that is essential for success.
EXTREME MARKETS BREED EXTREME BEHAVIOR
An investor’s long-term performance is often most impacted by their decisions at key points in extreme market environments: think October 1987, January 2000, September 2002 and March 2009. It is at these critical junctures that fear, greed and hope—as evidenced by physiological responses that produce adrenaline (fear) and dopamine (greed and hope)—are likely at peak levels. That’s when bad decisions are likely to occur. Our experience has shown that the most critical element contributing to long-term investor success is the ability to identify the behavioral biases that a prospective client is likely to exhibit. Some of biases are emotionally-driven (emotional biases), while others are driven by the use of mental shortcuts (heuristics) that people use to try and solve statistically-oriented problems. These short cuts often lead to incorrect conclusions based on faulty reasoning (cognitive biases). Fusion PsyFi™ determines these probable behavior patterns using certain techniques we have developed, including a thoughtful and detailed discussion regarding their past experiences and consequent behavioral-based responses. Helping make clients aware of their specific tendencies to exhibit certain behavioral biases from the outset of the advisory relationship – and reinforcing their awareness of these tendencies via continuing education – is a key component of the Fusion approach. This increases the opportunity for us to mitigate significantly the chance that our clients will allow these biases to interfere with their well-thought-out, long-term plans.