After 15 years of declining profitability for wealth managers, a new generation of behavioural finance promises to turn the tide. According to the BCG Global Wealth Report 2023, the pre-tax profit margins for global wealth managers experienced an average decline of 2.3 basis points in 2022. The decrease in profitability is attributable to escalating costs, whereas certain regions witnessed increased profits primarily driven by elevated interest rates. However, as BCG said: “Relying on high-interest rates for sustained benefits is not a viable long-term solution.”
Indeed, wealth managers must adopt fresh initiatives on both the revenue and cost fronts. The escalating competition and downward pressure on fees only underscore the necessity to increase assets under management (AUM). But despite declining profitability, the business model in wealth management has remained substantially unchanged, indicating that the industry now faces an innovation gap.
Indeed, a shift from traditional, product-focused, push-driven models to digitally enabled total client-centred interactions. Clients now demand transparent and individualised services with the same quality of interaction in person and digitally.
Using behavioural finance to empower wealth managers, enabling them to understand their clients better and enhance both performance and profitability. Indeed, after decades of advancements in behavioural finance, we now understand how humans make financial decisions and the cognitive biases that can hinder them from reaching their long-term financial goals.
Applying behavioural finance necessitates a robust scientific and technical framework. Traditional investor categorisations based on surveys are insufficient and are no longer perceived as a value-added exercise by advisers or their clients. Many existing profiling tools still apply simplistic approaches to determine clients’ risk preferences and entirely ignore behavioural biases, and making advisers unable to anticipate clients’ future behaviour when confronted with market ups and downs. However, clients still expect to be central to wealth managers’ business philosophy.
But behavioural finance goes beyond simplistic models. It has three pillars:
- Understanding cognitive biases and behavioural patterns that influence individuals’ financial decisions
For example, one of the most common financial decision-making biases is the confirmation bias. Confirmation bias occurs when individuals give more weight to information confirming their beliefs or decisions while downplaying or ignoring information that contradicts them. In financial decision-making, this bias can lead individuals to seek out or interpret information in a way that supports their preconceived notions about investments, assets, or financial strategies. It can result in suboptimal decision-making as individuals may overlook critical data that challenges their perspectives, potentially leading to financial losses or missed opportunities. One of the measures used to counter bias is confronting investors with relevant return characteristics about their investment horizon and goals during the profiling and onboarding process.
- Nudging for User Interface (UI) for inclusion
Behavioural interventions, commonly called nudges, can guide individuals toward making beneficial choices. We can promote greater participation by employing nudges, meaning accepting proposed investing solutions in digital and analogue formats. Simple examples of nudging include setting optimal default choices (e.g., optimal saving amounts for the client) that individuals tend to follow or providing social references by comparing with others.
- Data-driven insights and impact evaluation to keep innovation, research, and development rolling
This method employs rigorous data collection and Machine Learning-based (ML) analysis methods. By measuring outcomes and identifying areas for refinement, we ensure that future iterations are even more effective and better aligned with the individual investor’s changing needs. It makes digital tools responsive.
Application as of today
The three pillars implemented and integrated within wealth technology tools provide a robust link between individuals and investment solutions, allowing for personalisation at scale and the construction of optimal investment solutions that properly address individuals’ needs and risk attitudes, including the maximum loss the client can absorb. A well-specified link between individuals and the recommended investment solutions also permits a customer-centric narrative because the proposed investment solutions are constructed around the clients. It allows to offering complex structured products and illiquid products, such as private equity, in a way that customers understand and accept.
Effect
This approach makes investment tools far more personalised and responsive, highly scalable, and capable of offering complex products and solutions to increase AUM and profitability while maintaining clients’ happiness.
But applying behavioural finance does not provide an immediate effect. Instead, it leads to steady leadership and business success. That is why it is so easy to diminish the value of this know-how in seeking immediate gains or choosing the marginal know-how.
It seems unlikely that behavioural finance, even with the assistance of AI, will entirely replace the value of human interaction and advice. Instead, the most successful wealth managers will embrace a hybrid model that merges personalised service with a rigorous, quantitative behavioural finance methodology. This approach empowers wealth managers to develop a nuanced understanding of their clients, align with their values, and work towards their financial goals. The result is the provision of personalised investment solutions, leading to maximised risk-adjusted returns and profitability. Consequently, investment tools become highly personalised and scalable.
Interested in reading the full report? You can read this edition of the Swiss WealthTech Landscape Report 2024 online here.
