Tailoring the advice to suit the person

ONCE BITTEN, twice shy goes the adage. You can imagine then how skittish investors are as they battle their way through the second major downturn in a decade.

But, argues the investment management community, this is precisely the stage at which people should be looking to organise their investments to take advantage of an eventual upswing.

Despite the hoary tales from aggrieved investors nursing sizeable losses, there’s no future for investment managers in carelessly channelling their clients into portfolios that either don’t suit them or that are ill thought out.

The general starting point for investment or wealth managers is assessing the risk tolerance of potential clients. The trouble, according to Dr Greg Davies, is that traditional measure makes the mistake of assuming investors are rational creatures and will react in line with their pre-determined acceptance of risk throughout the life of an investment.

In fact, we are all essentially irrational – as evidenced most notably by our tendency to react to short-term setbacks or advances rather than longer-term trends.

Davies is a director at the investment and product office of Barclays Wealth. More pertinently, he is the man who has designed Barclays’ new approach to managing their clients’ wealth, first espoused by Princeton behavioural finance specialist Prof Daniel Kahneman, and the principles of psychometrics.

“The idea is that classical finance does not have the whole story,” says Davies. “We are not throwing out the old rule book but the fact is that people get irrational and we need to take account of that when it comes to their approach to investment.”

Davies maintains that while there is a lot of talk about pyschometrics generally in the industry, a lot of it is still lip service. There is, he argues, “little rigorous systematic application”.

Having spent the past three years refining its psychometric model, including testing it on about 5,000 people, the bank has begun to roll it out across its wealth management operation.

The system has been live in Europe for nearly two years and in the past few months has begun a rapid rollout across much of the rest of the Barclays Wealth operation, starting earlier this summer with Lehman’s North American unit. Since then, it has been applied to customers in Dubai, Hong Kong and Singapore. It has also been introduced to the Dublin operation, where Barclays has been a player for 30 years.

Essentially, rather than relying on the one measure of risk tolerance, Barclays’ financial personality questionnaire assesses people on six separate behavioural dimensions – risk tolerance, composure, market engagement, perceived financial expertise, delegation and belief in skill.

“One of the big failings of classical finance is its concentration on the end goal. It ignores the fact that you get a statement of account and that you react to gains and losses and take interim steps,” says Davies. “It assumes people stick with the approach agreed at the outset but we are not rational like that. We get overexcited at the top of the market and double up.”

Barclays believes that such short-term emotional decisions are detrimental to clients’ long-term investment return. It believes that, by getting a better picture of their clients and their approach to the market, they can pre-empt certain behavioural characteristics and tailor individual portfolios to minimise the possibility of precipitous action that might undermine long-term investment goals.

Barclays says its approach also takes account of the fact that people’s pleasure in making a gain is not the same as their fear of losing money. Davies says that, by a ratio of two to one or even 2.5:1, the fear of losing is greater than the pleasure of winning.

The other thing Barclays takes into account is the different approaches prospective clients will have to investing different types of income. A client may have a different attitude to how an inheritance or a bonus might be invested compared to money taken, say, from the general earned income.

Barclays says it adopts a layered approach to compiling individual portfolios, with the balance within and between layers determined by the outcome of the financial personality profiles.

At the bottom there is what is termed the “Stay Richer” layer of cash. People with a lower level of market engagement will generally need what Davies refers to as a “thicker security blanket”.

Above this come longer-term optimised and guided alternatives. The optimised portfolio will feature products designed to produce market returns and others aiming for absolute returns, while guided alternatives give people the chance to participate in more illiquid assets like private equity, property investment or hedge funds.

At the top of the pyramid are guided opportunities, where those more comfortable with their level of market expertise can take a more hands-on approach.

“If we have done our job right,” says Davies, “the client is more likely to buy into the portfolio we have designed and less likely to respond adversely to short-term movements.”

This, they hope, gets around the two major problems in the current environment – people who reduce risk when their investments start declining in value, thus locking in losses and people reducing their time horizons in period of crisis, which is simply counter-productive.

The payback for Barclays? Davies is quite upfront. Happy clients by their nature have a lower attrition rate and the bank maximises the potential to manage a greater share of their wealth.

In addition, they drive a greater level of referrals. Already, says Pat McCormack, head of the Irish wealth management business, the rollout of the new approach has seen a significant increase in referrals in the Irish market.

As a rule, clients will have several meetings with their wealth manager before deciding on their portfolio balance. The initial meeting serves to allow each side to assess the other.

A second meeting will involve explaining the financial personality profile questionnaire that they will complete.

Once complete, this is fed into a computer algorithm. This eventually spits out a personalised report that assesses the individual personality under each of the six dimensions. It is this report that will drive the composition of the eventual portfolio of investments.