Understanding human behaviours in the investment world can be of benefit to advisers
Behavioural finance looks at how psychological influences and emotions can affect the decision-making process and identifies how investors are assumed to behave, based on traditional theories. Established financial theory focuses on risk and return, whereas behavioural finance suggests investors are overconfident with respect to gains and oversensitive to losses.
An understanding of factors such as greed, fear and confidence levels can help financial advisers understand how investors make decisions and which actions should be taken to avoid some common pitfalls.
Some recent research1 by investment statisticians revealed that human biases, when investing, could cost the average investor 1.5 per cent a year in returns. This results in a loss of £24,000 for an individual making a £250 monthly investment over 20 years and a staggering loss of £274,000 over 30 years.
How can advisers use behavioural finance to benefit themselves and their clients? We consider these are the key areas to consider:
Loss aversion
Advisers have a key role to play in helping clients deal with loss aversion, by guiding them against a desire to sell winning investments and hold on to losers. They can also help clients to evaluate the prospects of an investment and identify whether it remains suitable, based on the individual’s circumstances.
Overconfidence
Advisers need to consider the potential for overconfidence in clients as well as in themselves. This could include advising clients against trading too much and honestly reviewing successes and failures, so that lessons are learned for future decisions.
Inertia
Encouraging clients to invest on a regular basis (pound cost averaging) and automatic portfolio rebalancing can be used to help clients overcome inertia to meet their financial goals.
Diversification
Clients often stick with investments that are familiar, which can result in a lack of diversification. Advisers have an important role to play here in emphasising the importance of a good spread of investments, rather than sticking with ones that are familiar.
Framing and mental accounting
Clients may have a mental framework for different pots of money, each of which may have a different objective and risk tolerance, for example a different risk tolerance for their pension compared to their ISA. The key skill an adviser needs here is to evaluate a client’s financial assets with as wide a ‘frame’ as possible, rather than focusing on the individual investment.
Advisers might consider developing an awareness of the different biases that exist and how this could impact investing behaviours. One way of doing this would be to widen the fact-finding exercise, which already involves some form of risk attitude questionnaire, to investigate other aspects of behaviour. For example, questions on risk could ask about the client’s tendency towards overconfidence in rising markets and undue loss aversion in falling markets, in addition to the usual risk versus return questions.
In summary, advisers might consider enhancing the advice process by:
- Evaluating clients’ decision-making styles
- Using behavioural checklists to check for common behavioural biases, such as overconfidence
- Developing formal investment policy statements relating to behavioural finance
Sources
1 Sunday Time supplement ‘Future of Investing’ 21.7.19
https://www.vanguard.co.uk/documents/portal/literature/behavourial-finance-guide.pdf
