Behavioural Finance

A guide for financial advisers

Simon Russell

• Publisher: Publicious Book Publishing
• Year: 2019
• ISBN:
  9780994610249
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Vermögensverwaltung

This book is a financial adviser’s guide to behavioural finance – the psychology of financial decision-making. Psychological research shows that often people don’t conform with ‘rational’ financial models and theories. Rather, they are subject to a range of decision-making biases. These biases are often deeply rooted in the way people think, in the structures and functions of their brains, in their shared evolutionary histories, in their social environments and cultures, in the lessons they have learnt from past experiences, and sometimes even in their genetic codes. However, because many biases operate beneath the surface of conscious awareness, their influence on people’s decisions can remain hidden.

This book dives below the surface of consciousness and asks: how can financial advisers use what we find down there? The answer is that advisers can use insights from behavioural finance to improve face-to-face conversations, risk questionnaires, fact-finders, advice documents, application forms, websites and investment reports. Behavioural finance can be used to better understand and influence clients, to manage an adviser’s own decision-making biases, and to improve organisational cultures and practices. And it can be used with clients ranging from those who are financially illiterate and overwhelmed, to those who think they are too sophisticated to be biased.

The first half of the book shows how behavioural finance can help advisers to better align their advice with a client’s risk profile, to assist clients to set goals and to spend their money in ways that lead to happiness, to provide financial literacy education that clients are likely to respond to, to coach clients through market cycles, and to invest in portfolios that exploit other investors’ decision-making biases. The second half discussed how advisers can help clients to avoid common asset allocation and diversification errors, how they can more effectively communicate with and influence clients, how they can assist them to buy residential property and to save for retirement, and how they can mitigate the impacts of conflicts of interest.

By discovering and influencing the real drivers of people’s decisions, the strategies discussed throughout this book have the potential to improve outcomes for advisers, their clients and the organisations advisers represent.

1

BEHAVIOURAL FINANCE AND THE SUBCONSCIOUS MIND

Probably for most financial advisers, behavioural finance is not entirely new. Many have read at least one book describing experiments that demonstrate humans’ money-related fallibilities. Some have attended workshops and conferences that have discussed aspects of behavioural finance and decision-making biases. And if they haven’t read the books or attended the conferences, they have almost certainly witnessed firsthand examples of apparently irrational financial decisions made by their clients.

Despite this, I sometimes find that advisers’ knowledge of behavioural finance is patchy, with many being familiar with some core concepts from the field, but not with others. In addition, some advisers lack a conceptual framework to integrate behavioural finance into the way they think about investment issues, and into the way they work with clients.

The purpose of this chapter is to fill these gaps, by outlining the key themes and concepts from behavioural finance that are relevant in the context of financial advice. For example, how does behavioural finance differ from traditional approaches to investment decision-making? From what perspective and evidence base are insights drawn? What are some of the ways that people’s decisions can be made or influenced beyond their complete conscious awareness or control? And what are the potential implications for advisers and their clients? In answering these questions, this chapter lays the groundwork for the strategies and applications that are discussed throughout the remainder of the book.

THREE VIEWS

Financial decision-making can be viewed broadly in three ways. These are the ‘normative view’, the ‘descriptive view’ and the ‘prescriptive view’. The normative view represents what people theoretically should do, and it forms the basis for traditional finance theory. The descriptive view challenges this theory by describing what people actually do when faced with various financial and investment decisions. In turn, the prescriptive view combines finance theory with insights about actual behaviour. In doing so, it seeks to identify practical strategies that can lead to people achieving better outcomes. What follows is a whistle-stop tour of the three views, how they differ, why each is useful for advisers to understand, and some of the strengths and limitations of each.

The normative view

The normative view refers to what people should do if they were fully ‘rational’; that is, if they were able to process all available information perfectly and free from any cognitive or emotional limitations. This view forms the basis for the often elegant and sophisticated models that underpin traditional economic and finance theories, some of which are discussed below.

According to these traditional models and theories, people should make decisions that maximize their ‘utility’ (or happiness) across their lifetimes. In doing so, there are assumed to be diminishing marginal returns to consumption. This means that people are assumed to get more pleasure from the first dollar they spend at each point in time, compared with the pleasure from spending their second dollar or their hundredth dollar.

As a result of these diminishing marginal returns, maintaining a relatively stable level of spending across a person’s lifetime is likely to create greater utility than alternative spending patterns that involve periods of relative feast and famine. Put differently, we should expect ‘rational’ people to engage in ‘consumption smoothing’ (ie saving during periods of relatively high income, and dissaving or borrowing during other periods). This is referred to as the ‘Life Cycle Hypothesis’.

With the wealth they accumulate from their savings, theoretically rational people are assumed to invest in a way that maximises their expected return for a given level of risk, or minimises their risk for a given return. To achieve this, they undertake a process of ‘mean-variance optimisation’ in accordance with ‘Modern Portfolio Theory’ (MPT). This process involves calculating the expected returns and co-variances of different investments and building an ‘efficient frontier’ of ‘optimal portfolios’. From these portfolios individuals then select one that suits their preferences for risk and return.

In this rational world, because it is suboptimal to accept risks that can be avoided through diversification, everyone holds a broadly diversified portfolio. And because everyone is holding diversified portfolios, nobody cares about ‘idiosyncratic risks’ (ie risks related only to specific investments, rather than to broad market or economic factors).

Theoretically, the only risk that these rational investors care about is how much each investment contributes to the overall risk profile of their portfolios. This risk contribution is referred to as an investment’s ‘beta’. According to the ‘Capital Asset Pricing Model’ (CAPM), this beta can then be used, in combination with the risk-free rate of return and the market risk premium, to value individual investments.

Finally, because these theoretically rational investors process information immediately and perfectly, there is no point anyone trying to beat the market. Rational investors will still face uncertainty in this theoretical world, but there would be no pricing anomalies or inefficiencies for them to systematically exploit, at least not by using publicly available information. This, of course, is known as (one form of) the ‘Efficient Markets Hypothesis’ (EMH).

The descriptive view

In contrast to the normative view, which suggests what fully rational investors theoretically should do, the descriptive view examines how people actually behave and make decisions. Psychologists, neuroscientists, behavioural finance researchers and others have used a range of techniques to learn about the financial choices people make. In controlled laboratory experiments they have analysed the impact on people’s choices of slight variations in the way those choices are framed. They have studied people’s brains while they make decisions from inside neuroimaging devices. They have collected saliva samples and assessed changes in people’s hormone levels after they encounter stressful decisions. They have tracked people’s eye movements to see what parts of a decision they most focus on. They have explored links between people’s behaviour and patterns in their DNA. And, importantly, they have measured people’s financial choices and outcomes in the real world, both with and without the benefits of financial advice.

What this research shows is that often people don’t conform with ‘rational’ models and theories.¹ Rather, they are subject to a range of decision-making ‘biases’. These biases are often deeply rooted in the way people think, in the structures and functions of their brains, in their shared evolutionary histories, in their social environments and cultures, in the lessons they have learnt from past experiences, and sometimes even in their genetic codes. While the evidence from these studies is often stark, because many biases operate at a subconscious level, their influence on people’s decisions can often remain hidden.

The descriptive view challenges a number of traditional financial theories and models. For example, rather than methodically engaging in consumption smoothing, in the real-world people struggle to resist the urge to consume in the present and to save for retirement. Lifetime consumption can also be far from smooth for people who fail to appropriately insure for life-changing events, such as the risk of them suffering an injury that leaves them permanently incapacitated. As advisers would be well aware, these risks can result in substantial hardship for individuals and their families.

Not even Harry Markowitz himself, the founder of MPT, tries to calculate covariances when choosing portfolios, at least not all of the time. When asked how he determined his initial pension fund asset allocation, he reportedly said: ‘I should have computed the historical co-variances of the asset classes and drawn an efficient frontier. Instead, I visualised my grief if the stock market went way up and I wasn’t in it – or if it went way down and I was completely in it. My intention was to minimise my future regret. So I split my contributions 50/50 between bonds and equities.’² If Nobel Laureates don’t conform to the rational models they themselves developed, what hope is there for mere mortals?

Similarly, flaws have been found with the assumptions, behaviours and outcomes relating to other traditional financial theories. For example, counter to the CAPM, beta does not appear to be the only measure, or even a very good one in some cases, that is relevant for calculating expected returns. Several other measures have also been found to be important. These are often referred to as ‘risk-factors’, and include value, quality and momentum. Each can be at least partially explained using psychological research. And, counter to the EMH, arguably some of these types of anomalies can be exploited by savvy investors to earn additional returns, without requiring them to accept additional risk. Traditional financial models and theories might be elegant, but the real world is messy.

The prescriptive view

Given the challenges to traditional models and theories, should financial advisers discard the normative view, replace it with the descriptive view, and spend their time hunting for market anomalies? Not so fast! Both the normative and descriptive views have strengths and weaknesses; neither of them is definitively superior. While there are flaws in some of the assumptions on which traditional models are based, these models can still provide useful frameworks to work from. Just because people don’t undertake mean-variance optimisation doesn’t mean that they shouldn’t diversify, for example. Advisers clearly shouldn’t throw out the diversification-benefits-baby with the incorrect-theoretical-assumptions-bathwater.

And just as there are strengths with the normative view that mean it shouldn’t be entirely discarded, there are also weaknesses with the descriptive view that mean it shouldn’t be entirely adopted. What works in a relatively simple, controlled laboratory environment might not work in the relatively complex, uncontrolled real world. The real world is different from what is assumed by theoretical financial models, but it is also different from the artificial world created in universities’ psychology departments.

The prescriptive view is a compromise. Rather than adopting either the normative or the descriptive views, the prescriptive view seeks to take the best of both approaches and combine it with a large dose of practical reality. In doing so, it attempts to answer the all-important question: ‘given what we know, what should real people do in the real world?’ Answering that question in the context of financial advice is the purpose of this book.

The realities of the real world that the prescriptive view seeks to incorporate can sometimes make a big difference. For example, while decision-making biases might lead to market anomalies, the practical reality is that arbitragers could eliminate those anomalies or transaction costs could make them uneconomic to exploit. Despite the apparent flaws with the EMH, if active managers are unable to effectively exploit market anomalies then arguably investors should invest as if the EMH were true.

This would also be the case if some active managers could systematically exploit market anomalies but investors and their advisers were unable to reliably identify those successful active managers ahead of time. In this case, determining what investors should do requires understanding the issues and opportunities created by several layers of decision-making – how investor behaviour creates market anomalies, how asset managers exploit those anomalies, and how investors and advisers select asset managers. These topics are addressed in subsequent chapters.

What about MPT? Even if advisers can reliably create an efficient frontier of optimal portfolios, choosing between them can be difficult. Selecting the most appropriate portfolio requires understanding each client’s preferences for risk versus return. The normative view assumes that these preferences are known, but psychological research shows that if not carefully measured, a client’s risk tolerance can be easily obscured by their recent experiences, or by the way risk profiling questions are framed. And determining a client’s financial goals is not straightforward either. The psychological challenges advisers face in understanding clients’ risk tolerances and in identifying their goals are discussed in Chapters 2 and 3, respectively.

The traditional theories and models of the normative view, and much of the psychological evidence of the descriptive view are now well established. In contrast, the prescriptive view is at the bleeding edge of behavioural finance. In building upon the normative and descriptive views, the prescriptive view incorporates the results of initial attempts to apply psychological insights to improve people’s financial decisions.

Some of these initiatives have been well-designed, have had their results rigorously recorded and analysed, and ultimately have had papers about them published in peer-reviewed academic journals. While the results of initiatives that fail to meet these lofty academic criteria need to be viewed with some scepticism, they can nevertheless be informative for advisers too. They can reveal where psychological insights interface with practical challenges and commercial realities, for example. Lessons from both published academic research and unpublished industry initiatives are discussed throughout this book.

KEY DECISION-MAKING CONCEPTS

The remainder of this chapter provides a short summary of six of the important decision-making biases that are relevant in the context of financial advice. While each is separate, the key theme that connects them is that they often occur beyond people’s conscious awareness. When people introspect they might find apparently rational, considered explanations for their decisions. However, the psychological research shows that conscious processes often play a smaller role in people’s decisions than they imagine. As a result, some of the reasons that clients provide advisers to explain their decisions are likely to be merely post-decision rationalisations. These explanations are constructed to cover the real reasons for clients’ decisions, reasons that lie beyond the reach of their conscious experience.

1) People are too sensitive to losses

That people dislike losses is unlikely to be news to many financial advisers; of course, people would rather have gains than losses. However, behavioural finance research provides a deeper and richer understanding of people’s relationship with losses. This allows advisers to better understand their clients’ tolerance for accepting risk. Psychological insights can also assist advisers to better understand and influence the way clients respond to the losses that they experience.

One of the key psychological insights about losses is that people’s dislike of them can be disproportionately large. Psychological research typically demonstrates that the prospect of suffering losses impacts people’s decisions roughly twice as much as does the prospect of achieving equivalent sized gains. This is referred to as ‘loss aversion’, and uncovering it contributed to Daniel Kahneman winning a Nobel Prize in Economics.

There are a number of reasons why loss aversion can be important in the context of financial advice. For example, seeking to recoup their losses might contribute to a client making things worse by ‘throwing good money after bad’. Ironically, as in this example, some attempts to avoid losses can actually increase the risk of a client experiencing them. This problem, in part, underpins the ‘disposition effect’ and short-term momentum, both of which are discussed in Chapter 6.

Another example of how loss aversion can cause a problem is if an investment gains $15k, followed by a loss of $10k. While the total return in this case is positive, if people are twice as sensitive to losses as gains, the psych...