“Human decisions are made with 80 percent emotion and 20 percent logic. In finance, that is higher at 90 percent. Unfortunately, when people follow their natural instincts, they tend to apply faulty reasoning to investing. Ego and emotion are the twin enemies of sound investing and must be kept out of the investment process. That is becoming harder today as there is an inherent belief that a complicated investment landscape requires complicated solutions. Family offices are increasingly offering their clients complex products to differentiate themselves in the market, but that means they are making emotion-free investment decision-making even more difficult,” according to Matt Topley, Chief Investment Officer, Fortis Wealth.

Topley is a speaker at the marcus evans Private Wealth Management Summit 2018, taking place in Las Vegas, Nevada, March 15-16.  

What do CIOs and wealth managers need to know about behavioral science? 

In today’s 24-hour news cycle, we are constantly bombarded with negative information that we think will affect the markets. That skews decision-making. Secondly, our biggest enemy is our ego. The ability to evaluate one’s own ability is the most important skill of all, and ego makes it difficult every step of the way.

How can family offices ensure their clients’ investment decisions are not influenced by emotions?

They should develop an investment process that removes human emotions as much as possible. They cannot be completely removed, but technology can help them set up an investment model that removes emotions from a lot of the decision-making.

Factor-based investing is gaining in popularity. It is based on academic research, completely removing emotions from the stock picking process. There is a massive move towards passive investing, although that does not necessarily remove emotions. People can still make the same emotional mistakes around indexing as with stock picking. Success is more about having a well-diversified portfolio set up for the long run, making a plan and sticking to it, than about picking the next Apple.

Family offices are becoming their own private equity firm or hedge fund, and there is good and bad side to that. They are seeking complexity that is not needed. They believe they have to offer complex products to be stand out, but that is resulting in even more emotion-based decisions. They can still differentiate themselves through real estate, private investments, but in the public markets their focus should be on keeping fees low and tax efficiency high.  

What are the most common misconceptions or traps that CIOs fall into? How can they be avoided?

The top biases are the following. The “recency bias”, where investors evaluate portfolios based on recent results, making incorrect conclusions that lead to emotional, incorrect decisions. The “illusion of skill” that causes people to overestimate their skills and underestimate their negative skills. Thirdly, the “halo effect”, where we believe that someone with a likeable personality or desirable trait can do no wrong. It may seem shocking but hero worshiping on Wall Street is quite common. Investing is not an IQ game. It is a psychology game.

How can family offices prepare their clients or train them to avoid such traps?

There are good psychology tests available to identify the investment personality type of the family. They can identify their thought process and mistaken beliefs, and review it with the family. They should do this in a bull market like this, before the next recession.

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