We’re all predictably irrational. Evolution gave us a set of reflexes for fast decision making that override our thought processes, largely because these reflexive responses have strong emotive content.
These hard-wired psychological biases are something advisers simply must understand if they’re to be able to guide clients to good solutions, because they’re the real source of the fear-greed dynamic that drives financial markets.
The instincts that helped us avoid being eaten by the sabre-toothed tiger evolved to include overrides, just like what happens when you jump out of the way of a bus before you start to think. But we apply gut-driven heuristics (rules of thumb) to all sorts of things that didn’t exist on the African savannah, including stock markets, where relying on instinctive-emotive responses can result in being skinned rather than being saved.
Because we’re poor at assessing probabilities, we instead rely on gut responses to decide whether something’s risky. We use single reference points (useful for running away from danger) to assess complex situations, where they just don’t work. We value what we’ve got far higher than what we haven’t (on the savannah, the meal in the hand was worth many meals in the bush), so the ‘endowment effect’ biases our investment decisions. And so on.
However hard we try to be rational, we still get carried along by the wave. I lost count of the people I warned about the overvalued property market in 2006. In fact, I gave up telling people about the risks because they were running with the herd, had wrapped themselves in ‘magical thinking’ security blankets and just couldn’t hear. Of course, you weren’t among those people who in 2007 thought property prices could continue rising or simply stabilize and it would all be all right. You’ve probably used another of our set of mental tricks to edit your memories so you don’t have to remember being wrong (the regret of being wrong is so painful we’ll do almost anything to avoid it). In fact, most financial advisers are every bit as irrational as their clients – and I’ve met a few for whom that’s an understatement.
So for financial advisers, the behavioural finance problems are twofold. One: identifying biases in your clients and trying to prevent them from severely damaging the client’s interests. Two: trying to identify areas in which you are being affected by herding and other reality-bending mental quirks.
Behavioural finance isn’t some new box of tricks nor one that contains any magic bullets. Charlie Munger, Warren Buffett’s long-term partner at Berkshire Hathaway, has been saying for the past 30 years that identifying your own biases and correcting for them is the most difficult and rewarding thing you can do as an investor.
If you apply this discipline successfully, you may become as even-handedly dull about markets and portfolios as investment advisers used to be in the old days before investment got exciting. People who believe investment is exciting shouldn’t be investment advisers, though they may make good fund managers.
Should you tell your clients they’re being irrational? Ouch. But what if you don’t? (Ombudsman: So you knew the client was behaving irrationally but you did not point this out to him?)
Before tackling that issue, assess your own ‘irrationality’ and work out what you have to do to correct it. Then think about how you can apply that to your clients. You’ll probably discover that many of them are less irrational than you are.
Chris Gilchrist is director of Churchill Investments and editor of The IRS Report
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