The power of behavioural finance

Smart practice

Monday 05 December 2016

Behaviours and unconscious bias have an impact on our ability to build wealth

Behavioural finance is a fascinating field, that attempts to explain why we invest the way we do. The insights this field delivers have implications for retail and institutional investors, as well as advisers. It’s worthwhile for advisers to understand what these are and apply these learnings to their own practice.

As Vikash Ramiah, Associate Professor in Applied Finance, School of Commerce, University of South Australia explains, behavioural finance draws on psychology to understand the behaviour of market participants.

“First we try to understand the behavioural characteristics of a person in terms of overconfidence, loss aversion and representativeness. Then we predict what sorts of mistakes they may succumb to when it comes to financial decisions,” says Ramiah. Representativeness is how well or accurately something reflects a sample.

“A problem well-stated is a problem half-solved. If we know what biases people are prone to due to personality, disposition and upbringing, we can predict the mistakes they are about to make. We can also prevent them from making these mistakes and encourage them to act in a rational manner,” he adds.

One example is the concept of anchoring, which is the inclination to become fixated on one piece of information, for instance a particular share price value you expect a stock to reach. Once investors and their advisers understand this psychological effect, they can try to ensure they are not anchored to one idea and change their behaviour to make better investment decisions.

Simon Russell, Director of Behavioural Finance Australia, says the major downturn experienced during the financial crisis of 2007/2008 heightened interest in behavioural finance.

“We make decisions that are psychologically self-serving, or that take away anxiety, but are not necessarily self-serving from a financial perspective.”

A common example is people responding to falling markets by becoming more anxious and wanting to sell, and responding to rising markets by wanting to buy more.

While all advisers seek to understand the risk appetite of their clients, those taking a behavioural finance perspective will attempt to gain a deeper understanding of what drives their clients’ psyches.

These behaviours are challenging for financial advisers when dealing with clients whose natural instinct is to sell when the price of an asset has bottomed out and buy when the price of an asset is outperforming.

Nevertheless, investors find it hard to overcome their natural instincts, which often have negative outcomes.

Behavioural finance roots

As Ramiah notes, behavioural finance first emerged as a discipline in the 1970s, with the work of Amos Tversky and Daniel Kahneman, the 2002 Nobel Laureates.

“Around 2005 behavioural finance was at its earliest stage in Australia. Some finance academics rejected the notion as they strongly believed in market efficiency, that is, the market is always correct and there are no bubbles,” says Ramiah.

“With the help of some open-minded academics, behavioural finance is now a well-recognised discipline and the next generation of behavioural finance experts is now emerging,” he adds.

Ramiah says some countries are experiencing a swing from traditional finance to behavioural finance. “In China, for example, it is believed that irrationality prevails most of the time as traditional finance theories fail to explain Chinese market behaviour – behavioural finance appears to be a saviour.”

For instance, behavioural finance has identified that investors tend to act as a herd, which explains why the Chinese market is so volatile: everyone sells and buys at the same time.

The benefits of mindfulness

When it comes to applying behavioural finance concepts to clients’ portfolios, Ramiah says it is important to understand the psychology of the client.

Advisers should explore whether clients are risk averse or risk takers, and whether they are prone to any biases. While all advisers seek to understand the risk appetite of their clients, those taking a behavioural finance perspective will attempt to gain a deeper understanding of what drives their clients’ psyches.

“If you leave it to a client to make investment decisions, they will often make mistakes. They will fail to diversify, trade on noise rather than information, overreact to new information, hang onto their losses for too long, get out of their winners too early, trade excessively and underperform market indices,” Ramiah explains.

“Clients can benefit from being educated about behavioural biases to prevent these mistakes from happening.”

However, financial advisers also need to consider how their biases may affect the advice they deliver to clients.

For example, an overconfidence bias, which means an adviser risks being more positive than they should be about clients’ financial position and ability to build wealth. This means the adviser may, for instance, not recognise signs a client is in financial trouble and therefore not recommend appropriate strategies to avoid this situation.

In contrast, an adviser displaying loss aversion bias could be more concerned about diversification of investments, savings patterns, insurance cover and the investment horizon.

Awareness matters

Russell notes that being aware of behavioural patterns is one way to counteract them. He also says it’s possible to take advantage of biases. One example is the ‘value effect’.

“Companies with value characteristics tend to outperform growth companies. This is underpinned by behavioural characteristics because forecasts for growth businesses tend to be too high, which leads to underperformance,” says Russell.

One way to overcome this is for advisers to tilt client portfolios towards value stocks, which should deliver a higher return for a given amount of risk.

Another opportunity is for advisers to distil a broad range of options into only a limited range for clients to choose from, and frame the choices so clients can easily compare them.

The ‘familiarity effect’ is another common bias, says Russell. This involves clients only investing in assets they know well, such as the Australian share market. It means they don’t invest in other assets that also have the ability to drive returns, such as international shares.

One way around this, says Russell, is to demonstrate that a portfolio of international stocks has companies clients may be familiar with, such as Apple and Facebook, which will help to reduce their anxiety.

“This also works to create a more engaged client experience,” says Russell. He adds the familiarity effect can also be taken into account in the client experience. For instance, advisers who include their photo on their email signature help to make the client more familiar with them, which will help reduce any anxiety associated with using an adviser.

Behavioural finance is a fascinating field, with significant implications for advisers and their clients. It’s worth taking an interest in developments in this field to put clients in the best position possible.

8 behavioural finance tips for advisers

  1. Build bias exploration into the initial client fact-finding process. Create a questionnaire for clients to use that uncovers their biases. For instance, ask them how they felt the last time they lost money on an investment. Or ask them if they prefer dining in an empty or full restaurant to get a feel for how influenced they are by ‘herd bias’, the propensity to go with the herd.

  2. As an adviser it’s important to explore your own biases and how they affect the way you deliver advice. Consider if you are prone to anchoring – the inclination to become fixated on one piece of information, for instance a particular share price value that you expect a stock to reach.

  3. Assess your own financial decisions and how biases have influenced these in the past. Look at which decisions have produced good returns for clients and which haven’t and use this knowledge to inform future investment decisions.

  4. Encourage clients to visualise their financial future, for instance the type of house they want to live in when they are retired, or the type of car they want to drive. Understanding this will help when making future financial decisions because they can reflect on how the decision will help them achieve their vision of the future.

  5. Develop long-term financial goals and plans for clients to help them direct their decision making. If they do want to make irrational decisions, you can explain how that decision might reduce their ability to achieve the financial future they want.

  6. Foster a relationship with clients in which they feel comfortable uncovering their anxieties about their financial future. It’s often these anxieties that lead to poor decisions, so knowing what they are will help to understand triggers for making poor financial decisions.

  7. Ensure you and your clients understand how loss aversion works. This is the idea that we are more concerned about losing money than we are about making money. This can result in investors not wishing to exit loss-making investments, leading to further losses. Simply understanding this concept can help clients to reduce the impact of loss aversion on their ability to build wealth.

  8. Recognise when clients are suffering from inertia – an inability to take action – and implement strategies to reduce the impact of inertia on clients’ portfolios. This includes automatic rebalancing of portfolios and dollar cost averaging.

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