You cannot ignore how people think about money — and the methods by which they psychologically separate their cash into different “buckets”. One bucket for retirement, one for vacations, a couple for kids and education, and so on. Advisers are taking a greater interest in these thought processes in order to understand how they affect investor decision making.

Drew McMorrow, chief executive of Massachusetts-based Ballentine Partners, is one of a growing number of wealth advisers who believe in behavioural finance. He applies a method to help clients better understand their mental accounting decisions to fit his clients’ aspirations into an investment strategy, because different portfolios will have different goals and varying degrees of risk.

Mr McMorrow says this method helps his clients understand and confront their behavioural biases when investing. If someone is scared of losing money, for example, they can better deal with market downturns if only a few “buckets” are affected.

Over the past decade, behavioural finance researchers have been trying to understand the psychological principles that govern investor behaviour, such as an aversion to losses.

The concept, says Nicholas Barberis, professor of behavioural finance at Yale University, has been used to understand why many people are uncomfortable investing in risky asset classes.

© David Bromley

At the other end of the spectrum is overconfidence, when people overestimate their ability relative to others and overestimate the precision of their forecasts.

“This has been rigorously linked to excessive trading in brokerage accounts and to the associated poor investment performance,” says Prof Barberis.

Using modelling and big data analysis researchers have found that people often attach too much importance to outcomes they have personally experienced. An investor will be more comfortable investing in the stock market if they have experienced good returns.

“This is called the ‘experience effect,’ and it isn’t optimal. We should pay attention to all past data, not just the data we have lived through,” says Prof Barberis.

He adds that we still do not know for certain which are the most important psychological principles that affect our investment decision-making processes. He also believes that consensus about what might be sound investments may be different in the future.

For example, one commonly understood principle is extrapolation, when people think past performance is a good guide to future outcomes. As the legal disclaimers on mutual fund advertisements state, however, this is not the case.

Michael Liersch, head of behavioural finance at Merrill Lynch, says he thinks that investors should approach concepts of behavioural finance with a healthy degree of scepticism.

He maintains that simply acknowledging that investors have preferences and biases can help them better understand their own trading and asset allocation decisions.

“Traditional economists shied away from emotion in the marketplace,” says Mr Liersch. “But the market proved to be anything but dispassionate.”

Jordan Waxman, managing partner of New York-based HSW Advisors, agrees: “The market is based on myriad emotional decisions and gut reactions.”

Mr Waxman, whose firm is part of national adviser HighTower’s network, says he often sees investors inappropriately “anchoring” their investing. “All they’re thinking about is the price in which they bought and the price at which they want to sell,” he says. “This creates lopsided portfolios.”

Mr Waxman says he tries to understand his clients’ goals in a bid to comprehend the psychology of their investment decision-making.

“Investors usually think and talk in terms of emotion, and it’s the adviser’s job to work out which emotions are impacting their decision-making,” says Mr Waxman, who explores his clients’ early experiences of money problems — such as where they come from, what moves clients and what information they have received in the past. “These experiences translate into their values and can drive their behaviours towards investing,” he says.

Whether it is judging the suitability of an investment for a particular client — the regulatory bar that governs broker-dealers — or putting the best interests of the client first, Merrill Lynch’s Mr Liersch argues that the principles behind behavioural finance are directly in line with regulatory constraints on the industry.

Fiduciary rules, under which registered investment advisers operate, require the adviser to put the best interests of the client first. That’s exactly what behavioural finance does,” says Mr Liersch.

Prof Barberis is quick to point out that behavioural finance is still a young field, and so far the research has focused mainly on understanding the psychological drivers of investing behaviour — specifically investing mistakes.

“Sometimes, we can be too casual or too quick when trying to diagnose the root of someone’s investing behaviour,” says Prof Barberis. “Even if we can successfully identify the faulty thinking behind an investment decision, it’s hard to know how to change it. People have wrong-headed intuitions about how to invest, but these intuitions are often strongly held and hard to change.”

A guide to the language of behavioural finance

Experience effects
Attaching too much importance to outcomes you have personally experienced. You should pay attention to all past data, not just the data you have lived through.

Thinking that past performance is a good guide to future performance. It is not.

Loss aversion
When you are more sensitive to potential losses and can miss the out on the benefits of a riskier investment strategy.

Overestimating your ability, relative to others, and overestimating the precision of your forecasts. This leads to excessive trading and the associated poor performance.

Source: Professor Nicholas Barberis, Yale University

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