What is behavioural finance? Is it more mumbo-jumbo?

We all know the financial services industry is full of incomprehensible jargon. To be honest, it loves it, no matter how much it protests otherwise. You could also be forgiven for making the same accusation towards a new part of the industry – behavioural finance – which purports to cut through the nonsense and explain what’s really happening. As it’s invented its own language of biases, behaviours and complexities, I’ve tried to summarise some of the more common sense ideas below in what attempts to be plain English.

Remember, economic bubbles rely on investors getting it wrong. People see an asset increasing in value and want a share in that growth. So in they go. And the more who invest the higher the price of the asset goes (demand being greater than supply). This means still more people want to invest and on the upward cycle goes. Until someone, somewhere realises that this asset is now over-priced and decides to take their profit. The whole thing begins to crash like a stone. Everyone piles out at just the wrong time. Bought high and sold low. The same impulsive decisions can be seen when buying insurance, taking out loans and pretty much all aspects of finance.

Why do we keep doing it? Because we are hard-wired to do so. Here’s a few reasons why…

We don’t always interpret information well

What we see and hear can affect our view of how likely we think something is to happen. For example, we might believe that a particular natural disaster is more likely to happen than it actually is because of a frequently reported story across various media channels. Information overload (a real issue in the digital age) can also lead us to focus on incorrect or inappropriate inferences, unimportant data, or just get distracted by too much choice. Over-deliberation and sometimes misuse of information can result.

We tend to be over-confident

Anything can be explained with the benefit of hindsight, so we tend to become overconfident about the accuracy of our judgements and our ability to predict future events. That can include the likelihood of good events occurring or things working out well for us. For example, studies have shown that retirees tend to be overconfident that their income will cover them in retirement, underestimating how long people tend to live. In one study respondents estimated that 50% of people who retire at 65 in good health will live to 80, when the reality is more like 80% of men and 85% of women.

We don’t plan enough for change

What we see and hear can affect our view of how likely we think something is to happen. For example, we might believe that a particular natural disaster is more likely to happen than it actually is because of a frequently reported story across various media channels. Information overload (a real issue in the digital age) can also lead us to focus on incorrect or inappropriate inferences, unimportant data, or just get distracted by too much choice. Over-deliberation and sometimes misuse of information can result.

We’re inclined to procrastinate

If something – like starting a financial plan – feels a bit difficult and we can’t see a short term benefit, we tend to put it off, even if we know it’s good for us in the longer-term. Procrastination can lead to:

  • Under-researching products or investments and giving up too easily
  • Not reviewing things to make sure they’re still right for you and giving value for money
  • Hanging on to products and investments you no longer need

Unfortunately, there’s little evidence that simply being aware of procrastination is enough to overcome it, and even tasks requiring very little effort can be postponed indefinitely.

We’re tempted by instant gratification

This means we tend to make decisions based on what we want now, in the present, regardless of whether we suspect we might regret these choices later. We struggle to relate to our future selves, and the results for investors are often too little long term saving and too much debt.

We’re not objective about gains and losses

We tend to set our own rules for what makes a gain or a loss, rather than assessing a particular outcome on its own terms, and we tend to feel the impact of a loss about twice as much as a gain of the same magnitude. So we place a disproportionate weight on losses. That can make our decision making unstable and varied. For example, we might sell our house for way under its market value, but still choose to view this as a gain because we sold it for more than we bought it for. Another way of putting this is that we often avoid situations where it can appear that we made the wrong decision, even when it was the right choice. With financial decisions you might sell or hold a particular fund at the wrong time for exactly those reasons.

We tend to stick with previous decisions

The success of ‘default options’ for pension fund choices and contribution levels are an example of this. There is also clear evidence that people fail to shop around for better annuity deals when they retire and stick with their pension provider by default.

So what do you do with this now?

Not only can psychological factors like these lead to poor decision making on our part, financial businesses understand them and can manipulate them through their marketing and sales processes. See how many of these techniques you spot in all aspects of life, not just financial services.

For example, aggregator websites that you might use to compare and choose financial products may focus on specific criteria – often price – leading you to ignore other relevant details and encourage a quick purchase that may not be right for you.

From this you can see that in many circumstances, the most significant factor in failing to reach a financial objective is likely to be our own behaviour; by procrastinating and not saving for retirement, by impulsively buying funds at the top of the market and selling when they have fallen, or by focusing on the one particular criteria that a marketing department wants you to focus on.

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