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Gregg McClymont: Getting inside clients’ heads

It is hard to attend an adviser conference these days without a session on behavioural economics.

A discipline which first emerged in the 1970s, its insights into psychological biases have been profound. If human cognitive failure is almost hard-wired into our daily functioning, then finding a way to nudge individuals towards making good decisions becomes crucial.

The result in pensions has been auto-enrolment, attempts to “reframe” annual pension statements to increase engagement and understanding, reductions in the number of fund choices offered to pension scheme members and the white-labelling of fund choices.

The influence of behavioural science is evident in the advised space, too; not least in the construction of risk tolerance questionnaires. Designing them in such a way they capture unconscious biases is crucial. Annual reviews also shed a light on the short-term biases individuals bring to the discussion of long-term financial planning.

In fact, there is probably no profession that encounters these aspects of human psychology more often than advisers.

Dissatisfaction with the rational utility maximising model of human nature impelled the rise of behavioural economics. The former idea that people acted rationally to advance their own interests in their economic lives was influential, not least because it made macroeconomics as a discipline feasible.

If one could assume everyone behaved in the same way then one could model behaviour in the economy straightforwardly.

The marshmallow test might be familiar to readers. This 1960s experiment offered children a smaller quantity of treat immediately versus a larger quantity if they waited 20 minutes. For a minority, usually younger children, here-and-now consumption prevailed. Sometimes this is glossed as evidencing our inability to defer gratification.

Our brains are wired to prefer a small but definite reward now to a larger but indefinite reward later. This has clear implications for financial planning.

So does prospect theory, which demonstrates people dislike a prospective loss more than they like a prospective gain. Thus when offered a guaranteed £200 versus a 50:50 chance of winning £500 they will choose the former. But when offered a sure-fire loss of £200 versus a 50:50 chance of losing £400 they will choose the latter. Behaviour towards risk depends on facing gains or losses, which helps explain why investors often take profits when equity prices are on the up and choose not to sell in a bear market in the hope losses will reverse.

There are others too but the overriding insight of behavioural science is clear. As human beings we think “fast” and “slow”. The fast system is unreliable but cannot be wished away. The slow system demands the effort of trying to work things out, and it is this mental exertion people do not like doing.

For many, financial planning is exactly this. Too much like hard work. Better to get an adviser to do that thinking for them.

Gregg McClymont is head of retirement at Aberdeen Standard Investments

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