Wealth Strategies

Why Behavioral Finance Matters For Wealth Managers

Tom Burroughes Group Editor March 27, 2020

Why Behavioral Finance Matters For Wealth Managers

Behavioral finance is now such a significant topic that a specialist in the field who won a Nobel Prize for Economics advises a bond fund management titan. The subject even gets a turn in Hollywood.

(Editor's comment: we originally published this article on July 12 last year. In light of the big moves in global equities and the fears around the COVID-19 pandemic and what it means for our industry, we felt it entirely appropriate to re-issue this item. This news service intends to continue tracking thinking around this subject and how it can be used in practice by advisors and clients.)

When Richard Thaler won a Nobel Prize in economics in 2017, one of the fathers of “behavioral economics”, he helped entrench this discipline as one of the most important areas of study. Recently, Professor Thaler was named as an advisor by bond fund management titan PIMCO. Perhaps, even cooler than that, he was in a cameo role in the film version of Michael Lewis’ financial tour de force, The Big Short. When Hollywood comes knocking, you’ve made it.

Understanding how money affects human behavior and markets is a big deal. It’s not just an academic pursuit. And the wealth management sector – or parts of it – sees an understanding of what makes investors tick as a way to work out how to win and keep their trust. At a time when advisors fret about defecting clients, for example, any insights that give firms an edge win attention. A more difficult claim for this discipline might be that investors make more money than they would otherwise have done had they acted differently. Such a counter-factual claim is very difficult to prove in real life (humans haven't invented time travel). In some ways, however, the "cash value" is that investors may, if they understand themselves better, be calmer during market panics and be less arrogant about their gains, and generally sleep better at night (not a benefit to be sneezed at).

Regulators are taking notice. The UK’s Financial Conduct Authority, for example, has been talking about the topic in a series of discussion papers for some time. In the US, the Securities and Exchange Commission in 2010 - when memories were still raw from the financial tsunami - issued a hefty report for the Library Of Congress, entitled Behavioral Patterns and Pitfalls of US Investors. The SEC has continued to track this area. Watchdogs say investments and services must be “suitable”, but if advisors don’t fully understand how a client might panic in a financial wobble, for example, how can they advise them in a compliant way? It might be too far to say that advisors are putting customers “on the couch”, but it seems not far off.

So what is behavioral finance? Here are two definitions to get started: “An important sub-field of finance. Behavioral finance uses insights from the field of psychology and applies them to the actions of individuals in trading and other financial applications.” (Nasdaq.) “Behavioral finance, a sub-field of behavioral economics, proposes psychology-based theories to explain stock market anomalies, such as severe rises or falls in stock price. The purpose is to identify and understand why people make certain financial choices. Within behavioral finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.” (Investopedia.)

The discipline harnesses what we know about human psychology to understand that the decisions people make with savings, investments and spending aren’t as coolly rational and objective as one might think. Humans don’t, so the argument goes, start off in life with a mental “blank slate” but instead carry habits and tendencies that are products of millions of years of human evolution. (Some of these notions can be controversial – the field known as evolutionary psychology, drawing on ideas from Darwin and others, can carry political implications such as male/female differences.)

It is worth pointing out that it doesn’t necessarily mean that when a person thinks that they are acting rationally they not doing so, or that, on introspection, they have acted rationally and chosen a course of action which is an illusion, like something out of The Matrix movie. Rather, practitioners in this area generally seem to argue that the more we know about how we think, and how we can be biased, that paradoxically the more rational our choices ultimately will be. For example, a person who knows that they have a short temper in certain situations might be more careful about avoiding those situations; a person with an addictive personality might take care to avoid getting into environments where temptations exist, and so on.

The field comes as one might expect with a lot of terms, some of which explain ideas that seem obvious once they are grasped. For example, there is what is called “anchoring bias” – the trait of relying on the first piece of information that is encountered as a reference point (or “anchor"). Another is “confirmation bias” – a term relating to the tendency people have to listen to those who agree with them. “Framing bias”, in turn, is about how people judge information by how it is presented; a change in how a problem was framed can cause investors to alter how they reach a conclusion.

There’s “herding” – we are hard-wired to form crowds – hence events such as market booms and mass political movements. “Hindsight bias” explains how people don’t realise that they make mistakes and assume that after something happened, such as a big spike in the equity market, we knew it all along. So the list goes on to include notions such as “illusion of control”, aka the mistaken idea that people have more influence over events than they really do (as in the idea that people can consistently beat a market). Other concepts include “loss aversion” (people tend to hate losses more than they enjoy commensurate gains); “representative bias” (judging matters by appearance), and “self-attribution bias” (thinking that good outcomes prove how clever one is, not thinking of luck. Or, perhaps, arrogance.)

This publication has spoken to a number of organizations, such as the CFA Institute, Barclays, Seven Investment Management (the UK wealth firm) and Oxford Risk, to get a better handle on how they see behavioral finance affecting the wealth sector. We will describe these conversations in coming days.

Behavioral finance is one of the hottest new disciplines today, and it appears to have some intellectual staying power, suggesting that wealth managers will also need to be informed about it. Of course there have been academic trends down the years that have sometimes run out of steam or been superseded, such as the theory of rational expectations (this is the theory holding that investors use all available information about the economy and economic policy in making financial decisions and that they will always act in their best interest). 

Of course, the bookshelves are stuffed with works spelling out some new insight (often repackaged verities of old). It would be wise for wealth managers not to junk traditional ideas just to be seen close to the latest hot idea in the City or Wall Street. But when markets turn volatile – as they sometimes have recently – it is plain that understanding human psychology is going to be part of any wealth manager's mental toolkit. Time to put in some studying.

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