Becoming a mainstream discipline
Once the domain of a small number of economists and psychologists, behavioural economics is no longer a marginal discipline. There is a growing list of real-world applications: governments, marketers, media firms, and others have teams of experts applying research in practical ways to guide policy, sell products, or encourage consumers to click a link.
The study of how we make decisions has been somewhat slow to come to wealth management. In part, it may be because our industry is firmly grounded in the idea that markets work and are designed to harness the wisdom of crowds. While that’s true over a long enough horizon, those of us who monitor markets daily know that they’re not always efficient. And even when they work as intended – with assets eventually finding their fair value – there will always be costly investor errors along the way.
The costs of these cognitive and emotional biases are measurable and likely greater than one might think. According to DALBAR’s 2018 Quantitative Analysis of Investor Behavior, the average annualised return of the S&P 500 composite over the last 20 years was 7.2%, but the average equity investor earned just 5.29%. The main cause for this huge discrepancy is behaviour – a sobering fact I share with my clients. It’s often a fear or greed play – selling on lows and buying on highs. And it’s exactly why advisers are able to add value; we help clients to stay invested in tough times, or add capital during drawdowns, versus taking money off the table at the worst possible time.
Understanding the causes of sub-optimal decision making gives us an advantage. That’s in part because behavioural finance offers insights that show how people act irrationally in predictable and quantifiable ways – helping us to develop more considered and strategic investment strategies.
Become a better adviser by recognising irrationality
As wealth professionals, we tend to have very strong confidence in our abilities. Over time, that self-confidence becomes reinforced because, more often than not, our intuitions tend to be correct. However, if you’ve been managing money long enough, you know that you’re not always right; even the best-of-the-best are only correct 60-65% of the time from a relative basis standpoint.
To guard against “overconfidence bias” – the belief that one’s own abilities are greater than their actual abilities – my team started doing more and more work on behavioural economics and finance, making it a point to look for, challenge, and minimise biases in our own decision-making. Our process is to acknowledge that our views could be wrong and to take actionable steps, such as asking colleagues to poke holes in our analyses. Instead of spending all of our time looking for the next best idea, we have a greater focus on the potentially negative scenarios that could impact our current investments. This helps to ensure that we don’t miss a foreseeable pitfall because we’re blinded by overconfidence.