How and why behavioural finance can pay off for advisers
Using behavioural finance, advisers can prove their worth by helping clients to spot their investment mistakes and take a more logical and disciplined approach with their portfolios, writes Tim Cooper
Over the last few decades psychologists have done a huge amount of research into so-called behavioural finance. This identifies a wide range of cognitive errors that people tend to make with money – for example, they tend to use rules of thumb, stereotypes and anecdotes rather than strict logic in investment decisions.
Leading proponents include Daniel Kahneman and Amos Tversky who first created their ‘prospect theory’, about how people make decisions involving risk, in the 1970s. Much has happened in behavioural finance since then and many consider Kahneman’s 2011 work ‘Thinking, Fast and Slow’ to represent the latest thinking.
The implications for advisers in helping clients avoid these mistakes are clear, but Vanguard’s attempt to quantify this in a 2014 report has gained particular attention. While some have challenged Vanguard’s assumptions, many advisers have welcomed the research and quote it widely.
Craig Burgess, financial planning adviser at Walsall-based Blackstone Wealth Management and chief executive of Evidence Based Investing Portfolios, says: “Humans evolved as pattern-seeking primates. It means we have the instincts to hunt a rabbit, but that leads to a lot of mistakes in the more complex world of investment.”
One of the biggest investment mistakes is in believing that past performance is a guide to the future, says Craig. In addition to Kahneman and Vanguard, he recommends research by Dalbar Associates showing that investment results are more dependent on investor behaviour than on fund performance; investors who hold onto their investments have been more successful than those who attempt to time the market.
“We try to get away from the past performance story by using a passively- managed, evidence-based world, with diversification and low costs,” he says. “But we have to know our clients well to ensure they make these smart decisions. And we have to distil the huge amount of evidence on behavioural finance into digestible messages.”
Flora Maudsley-Barton, managing director of Altrincham-based Parsonage Financial Planning, says discovering behavioural finance has been the biggest single factor affecting how she operates as an adviser. She has read Thinking, Fast and Slow, a regulatory occasional paper on the subject and Nudge by Thaler and Sunstein, another popular text. The latter highlights the importance of making the best decision the easiest.
“Humans are good at making instant life or death decisions but struggle with more reflective ones,” she says. “They have the right to make mistakes, but the trick is to help them become more aware of these and to seek help with a more logical and disciplined approach through ongoing advice.”
Charlie Reading, managing director of Rutland-based Efficient Portfolio, agrees that behavioural coaching provides a huge opportunity for advisers to prove their worth. In collaboration with his discretionary fund manager, he uses psychometric testing linked to a range of behavioural finance concepts in his advice process.
“At its centre is the observation that investors feel losses twice as keenly as they enjoy gains – the essence of prospect theory,” he says. “It also interrogates other financial traits such as intervention risk, which is the risk that the client will intervene before the investment target date.”
3 top tips
Charlie offers three tips for advisers when putting behavioural finance theory into practice:
1. Use a dynamic approach, so that (where they want to) the client feels part of the decision-making process – for example, with live cash flow modelling and portfolio construction in meetings.
2. Focus on risk and show that there will be downturns. Include examples and emphasise that if they persevere through downturns then portfolios will deliver.
3. Be aware of ‘myopic loss aversion’ – the more frequently clients look at their portfolio value, the more averse to losses they can become.
Tim Cooper is a freelance journalist.
A version of this article was originally published in Zurich’s Advice Matters magazine.