Behavioural finance - touchy feely psycho-babble or financial planning essential? Laura Miller looks at the birth and evolution of a phenomenon.
If you asked someone, "do you want to lose money", the answer is undoubtedly going to be "no".
So everyone acts in their own best financial interest, right? Not according to the fathers of behavioural finance, Amos Tversky and Daniel Kahneman.
Never heard of them? Well you should have. Kahneman was awarded the Nobel Memorial Prize in Economic Sciences in 2002, and in both 2011 and 2012 he made the Bloomberg 50 most influential people in global finance list – despite being a psychologist.
Is behavioural finance worth advisers’ attention?
Why all the accolades? Well, during their research Tversky and Kahneman hit upon a series of behavioural biases, ways in which humans act contrary to their own interests.
They outlined several of these behaviours in their paper, Judgement Under Uncertainty (1973).
The paper is pretty dense but essentially what they found was that people do not act in the way you think they would, i.e. taking in all the relevant information and working out the likelihood of things happening.
Instead, Kahnemann and Tversky showed that there are regular patterns of irrationality lying behind people's behaviour that work to disrupt their attempts to be rational, including about investments.
These are: that we judge people based on stereotypes; we assess the likelihood of events happening based on our ability to retrieve from memory similar events; and that we tend to make decisions based on some arbitrary starting point.
Their findings were in direct opposition to what is known as "conventional" or "modern" finance, the type of finance that is based on rational and logical theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These theories assume that people, for the most part, behave rationally and predictably.
One of the most basic assumptions that conventional economics and finance makes is that people are rational "wealth maximisers" who seek to increase their own wellbeing. According to conventional economics, emotions do not influence people when it comes to making economic choices.
Kahneman and Tversky revealed that this assumption does not reflect how people in the real world operate.
So, how can behavioural finance compliment the financial planning process?
The US-based National Association of Active Investment Managers (NAAIM) released an interesting report in April looking at this very question.
The report, Three fundamentals, using active management, behavioural finance and planning to reach client objectives, states the fundamental reason for portfolio management is to meet clients' objectives rather than to beat the market.
It highlights the need to use behavioural finance to keep clients' emotions in check and help them avoid making decisions that will inevitably limit their ability to meet those objectives, thereby allowing them to stay comfortably invested in all market environments.
To achieve this, NAAIM recommends using a combination of active and passive investing to provide added diversification and help manage client emotions during volatile markets.
Another way an adviser can help a client make future pleasures, such as wealth, less remote is by devoting time to discussing it, helping the client to imagine their future happiness.
Clients sometimes fear they are missing out on the next big thing, or get spooked by a dip in markets. But by using behavioural finance, financial advisers can help them develop patience, become more future focused and better appreciate future gains.
Behavioural finance: Adviser head to head
FOR: Yellowtail Financial Planning managing director Dennis Hall
"I've long been intrigued by the behaviour of clients, like why would they do anything other than what I've suggested?! If I've understood the problem and presented the solution logically, what other forces are in play to cause them to do something else? The answer, it seems, lies in the emotions and biases that mess with our minds, and this is a fascinating topic.
"Gaining a greater understanding of how our behaviour sometimes doesn't work in our own best interests helps me understand my own irrational behaviour, and in turn helps me deal with my client's irrational behaviours.
"You can forget the passive versus active argument; behavioural finance is the real game-changer. If we can show our clients the behaviours that work against them, we stand a better chance of helping them achieve their goals, and put an end to the investment cycle of buying at the top and selling at the bottom."
AGAINST: Altior Vita financial planner James Brooke
"I don't think that behavioural finance can give you an edge on the market. It doesn't help us make a greater profit out of a market.
"Behavioural finance confirms rather than denies that markets are efficient. Just because an investor makes a bad decision doesn't mean the price of a stock is wrong – the market prices in herd mentality investing.
"The best way to capture returns is to invest in the market as a whole. Investing in asset classes is still the best thing to do even though people don't act rationally."
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