Beware of your inner self; Investors’ decision making is distorted by all sorts of in-built biases and prejudices

May 31, 2013 7:37 pm

Beware of your inner self

By Norma Cohen, Demography Correspondent

On a visit to the London School of Economics in 2008, the Queen asked the assembled professors why nobody had seen the financial crisis coming.

Her Majesty’s question was a pertinent one. Part of the answer is that there’s a big problem with conventional economic and financial theory. Many of the big ideas that underpin it – from Eugene Fama’s efficient market hypothesis to Harry Markowitz’s modern portfolio theory – are based on the assumption that, when it comes to investing, the human mind is rational.

The financial crisis, and the fact that it came as a complete surprise to the vast majority of investors, has blown a hole in the whole notion of rationality. No longer is it assumed that froth and bubbles will be smoothed out by “smart money” that knows enough to sell an overvalued asset.Traditional thinking about investment choices – particularly the trade-off between risk and reward – goes back to mathematician Daniel Bernoulli, who in 1738 developed what is known as “utility theory”. This states that investors take risk in proportion to the potential gain that is of value to them.

By that measure, a rich man should be willing to sell insurance against loss and a poor man should be willing to buy it. The marginal potential loss means little to the wealthy guy but would be catastrophic to a pauper, according to Bernoulli.

“Economists are wedded to the idea that there is some amount that is worth less and less to you,” says Nick Chater, professor in the behavioural sciences department at University of Warwick Business School.

But a new science of behavioural finance is emerging, led not by economists but by psychologists who argue – with masses of evidence – that we are far from rational when we invest. In fact, our brains are a kind of apothecary chest comprising all sorts of hidden drawers and cupboards, each containing biases and prejudices of which we are barely aware. We make mental shortcuts, known as heuristics, that assume as fact what is really no more than belief.

Our fallibility hasn’t gone unnoticed. The UK’s own financial regulator has taken note. Earlier this spring, the Financial Conduct Authority said it would look at how investor psychology affects decision making and issued a paper on behavioural finance.

“One of the most significant challenges for modern financial regulators and financial services alike is to recognise that we operate within a very human environment,” FCA chief executive Martin Wheatley said at the time. “A fallible world – not just of ratios and complex models but also responses, sometimes flawed, that behavioural economics helps us understand.”

It’s not just retail investors that are fallible. Professionals fall into the same traps. Chater points out that investment bankers systematically underestimated the odds of catastrophic loss. “Investors at all levels have similar biases,” says Paul Craven, co-head of distribution for Europe at Goldman Sachs Asset Management and an expert on behavioural finance. “The smartest investors are aware of their biases and take them into account.”

Investor education can help investors overcome their inbuilt biases to some degree, especially if they already have well-developed numeracy skills. Things like standardising and simplifying the information that financial products have to carry can help, but there are limits.

Greg Davies, head of behavioural and quantitative finance at Barclays Wealth, agrees that such biases will never be eradicated. “You’re never going to solve the problem because you can’t change human nature,” he says. He urges investors to manage their inner selves by – for instance – writing themselves “a constitution”. It should include things like setting firm limits on how and when an investment decision is to be made. “Things like: ‘I will only decide at the weekend’,” says Davies.

Better regulation might also help, because of the one-off nature of many financial decisions; you only buy an annuity once, for instance. But again, there are limits; requiring disclosure of conflicts of interest may just prompt the customer to re-evaluate his opinion of the adviser personally, for instance. And some factors can lead consumers to make no decision at all, a fact that has come up repeatedly in connection with self-invested pensions. Recent research from the Organisation for Economic Cooperation and Development concluded that when more than five or six choices are presented, investors almost always either decide not to save – a really bad idea – or chose the default option.

“Our view is that the context and details of how a decision is presented makes a huge difference,” says Rich Lewis, a director at consultancy Decision Technology. But for products that are only bought once in a lifetime, the path to better choices may be limited, he says. “There is very little learning that goes on in long-term investments.”