Behavioural finance is hot stuff. The subprime boom and credit crunch revealed such all-round lunacy that the assertion that we are all irrational is easy to accept.
Most people who work in Financeland find the experiments of behavioural social scientists entertaining. But advisers could probably benefit from using seemingly irrational ideas to help their clients towards better outcomes.
One well documented form of irrationality is mental accounting, a universal and dangerous example of a heuristic, or, as non-residents of ivory towers prefer to say, a rule of thumb. Rules of thumb save time, so humans , being as lazy as is consistent with survival, use them whenever they can get away with it. Which is most of the time.
The problem is that in Financeland you almost never do get away with using rules of thumb and the problem is that you do not know you have not got away with it until much later – as, for example, in having put half as much as you needed to into your retirement savings plans, a fact you only discover when it is far too late to do anything about it.
A classic example of mental accounting is this. Mr and Mrs Numberless are saving to buy a second home. They earn 3 per cent interest on the account they are using. At the same time, they owe £5,000 on a car purchase credit agreement on which they are paying 8 per cent interest.
Now it is obvious to us Financelanders that the Numberlesses would do far better to devote their house purchase savings to paying off the loan faster – effectively they would earn interest at 8 per cent instead of 3 per cent.
But the Numberlesses don’t see it like that. What they say is: “But this savings account is for the house. We know we have got the money because it is there. And we know we are paying the car loan off in line with the agreement we signed up to 18 months ago. What’s the problem?”
The key concept in mental accounting is the point of reference. We tend to prefer a single reference point because it is simple. Hence our tendency to keep things in separate boxes with single reference points, as the Numberlesses do. In financial terms, this can seem crazy, and often is, but there are some situations where it clearly does make sense – budgeting, for instance. Older advisers may remember people having jars on mantelpieces containing cash for rent, insurance and so forth. Which is not nearly as daft as paying the man from Provident Financial back his money at 50 per cent annual interest because you did not do your budgeting in the first place.
In fact, I wonder whether advisers shouldn’t make more use of mental accounting – after all, clients do.
For example, in creating investment portfolios, advisers are often trying to satisfy two conflicting desires. The client wants security, especially as regards income, but has also bought into the idea that he must achieve capital growth.
The conventional approach is to design one portfolio that balances these requirements. Not only does the client struggle with this, and with evaluating progress towards these goals, but so does the adviser, who can end up compromising one or other of these objectives without even realising it.
So why not sneak in a bit of mental accounting and have two portfolios? “This one is for the income and that one is for the new cars, holidays and handouts to the grandchildren”. Funnily enough, I bet most advisers have come across married couples who have effectively arrived at this solution for themselves.
Theory says this isn’t “optimal”? To hell with finance theory – after all, it was theory that nearly took us there.
Chris Gilchrist is director of Churchill Investments and editor of The IRS Report
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