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Irrational numbers

Chris Gilchrist

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

The individual who posts the best response to this article (as judged by the editor) in the next week will win a 6-monthly subscription worth £65 to the newsletter Chris edits,The IRS Report.

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Comments

There are 7 comments at the moment, we would love to hear your opinion too.

  1. Thank you so much for a truly insightful article.
    In true “physician heal thyself” mode I will pay off the short term bank loan with the Isa regular savings.(Interest rate naff!!).
    This assumes that I can locate the jam jar with the money in it.

    Once again thanks

  2. Good article. In the move to fee-based advice I’m conscious of the time that I spend with clients and so have a tendency to lump all of their savings needs together.

    Given that new cars are depreciating assets I normally recommend some form of financing (if the interest rate can be kept low) so that clients pay for the depreciation as they incur it, rather than trying to build up a lump sum for the new vehicle.

    Cars are an emotional purchase for many people. The true cost of ownership can be unexpectedly high whereas the monthly ‘rental’ is very clear and often leads to a re-evaluation of priorities.

    For example, one of my clients used to change his car very regularly at enormous expense. It’s a complete myth that expensive German makes hold their value better than the Fords and Vauxhalls of the world. When I showed him the true cost, he changed his priorities and diiverted the savings into his pension. He retired ten years ago, is still driving the same car and is perfectly happy with it. He reckons that he’s saved at least £50,000 so far.

  3. Good article but it is not always us or our clients that are irrational, often the key cause is conditoning. My partner spent her previous life as a performing musician until an injury forced her to turn to teaching. At one point she was teaching 10 hours a day on a cheap(ish) upright piano. She has always yearned for a Bluthner grand and has just bought one similar to that she learned on in the 1970’s. She cannot understand why she bought a new VW Golf in 2003 for far more money than her beloved Bluthner just cost. The conclusion? She found it quite rational to buy a car but felt it an outrageous indulgence to buy a piano, even though she could have charged more for lessons on better equipment. Clever marketing means very few follow Steve Laird’s client’s example, a car is a necessity after all. Isn’t it?

  4. I suppose the art of a good adviser is identifying which way the client thinks and then delivering a solutionthat matches it. When we fail and a complaint arises, it is because we have not matched the clients mental approach to things and explained how the solution suits and not neccessarily that we have assessed their attitude to risk correctly.
    We had our first complaint in a decade last August and I think this may well be what it comes down to as we changed the clients asset allocation to REDUCE risk and hence moved her excesseive monies with Northern Rock (this was 6 months before they crashed) and a Buy2let portfolio we moved £285k away from deposit with Northern Rock managing to loose her 5%, but reducing her IHT liability massively and reducing overexposure to property as she nearly bought another one which would simply have inflated the property loss and be difficult to sort for IHT purposes.

  5. The problem is that we can’t say ‘to hell with theory’ because as IFAs we are regulated, but the press can print anything. That said, as long as any extra costs are explained, or the theory behind the portfolio covered then I am sure we all do this as a matter of course. Anyway, cars are factored into the family budget aren’y they? I learned that a long time ago when I found working families expected a car payment and knew that when that could be paid off they would be upgrading and were looking forward to it, but never wanted to put any of their nest egg into it!

  6. Chris has some good points here. I use the Transact wrap account whenever I can and recently realised that you can segregate a portfolio into several parts at no cost. This means that, for instance, different segments can be earmarked for different purposes. Not only that, different fee levels can be taken – this comes in where the client keeps his share portfolio in th wrapper but deals with it himself.

    In a different life, I worked as a research chemist. On one project we altered four different variables to get the best result. Fancy maths was used to help. The biggest breakthrough came when we thought of doing the process in two separate stages.

    If you have thought of one way of doing something, always think of at least one more – it might be the winner.

  7. Excellent article.

    A friend of mine told me that he was offered £300 not to take a particular over-booked flight. The alternative would have resulted in him arriving home some two hours later. He had not accepted – he said it just didn’t seem worth it. He’s a fee-based IFA.

    “How much do you charge an hour?” I asked him.

    “£100” he said.

    “On which you pay tax at 40%,” I said. “So you net £60, without taking into account overheads. So you turned down an offer equivalent to receiving 5 hours earnings for 2 hours sitting around.”

    He had no answer to that.

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