Behavioural Finance, Part 10: How we apply the Insights of Behavioural Finance

Welcome to Part 10 of our Behavioural Finance series. This is the final, concluding part of the series. If you’ve missed the earlier parts of the series, you’ll find our Introduction to Behavioural Finance here, Part 2: Prospect theory and loss aversion here, Part 3: Availability and Representativeness here and Part 4: The Law of Small Numbers here and Part 5: Anchoring, Conservatism and Herding here and Part 6: Overconfidence and Under-Confidence here. and Part 7: Self-Serving Bias here and Part 8: Projection Bias & Magical Beliefs here. and Part 9: Mental Accounting

Throughout our 10-part series on behavioural finance, we’ve seen how our own biases and beliefs can affect our investment decisions and the knock-on implications this can have for our returns. The final question to consider is how we should address this.

The important thing to bear in mind is that the biases of behavioural finance aren’t ‘problems’ that we can ‘solve’. They are natural human behaviours that are apparent in many walks of life. We just need to learn to be aware of them and work with them. After all, we are all only human.

This, I think, is why behavioural finance is so exciting. It recognises us all – clients, advisers, investors – as humans. At First Wealth, this intelligent, people-focused approach is what our business is built on. We spend time getting to know our clients and understanding who they are, what makes them tick and where they want to get to. The reason we believe in behavioural finance is because it will help us to do this even more effectively.

Twenty years ago, giving financial advice meant selling financial products and packages, and earning commission. The world has changed since then. There is a quiet revolution of financial excellence emerging within the UK. New advice firms and new advisers have realised the immense power of financial planning done well. Financial planning carried out correctly can help you achieve your dreams and focuses as much on the goals of the individual as it does on the bottom line of the balance sheet. Great advisers are dealing with the psychology and emotional aspects of financial planning, rather than focusing on the money itself. There is a huge opportunity here to build on this success.

The best financial planning is always objective; we have a duty to tell clients what they need to hear, not what they want to hear. As we look to the future of our profession, it’s down to us to educate and reassure investors that we have their best interests at heart. For us at First Wealth, an appreciation of behavioural finance will play a huge part not just in this trust-building exercise but also in the future of the financial advice we offer.

So, how can we use a knowledge of behavioural finance to create great results? What does behavioural finance tell us about building up trusting relationships and the power of planning together? How can we use this insight to drive you towards your lifestyle goals? Here are some of the opportunities I think are waiting for us.

Raising awareness

Knowledge of behavioural finance should be an addition to traditional investment theory, not a replacement. Growing numbers of advisers are beginning to see its benefits and we need to spend time with clients, help to identify the individual biases that affect them, how this will impact their decisions and flag up the warning signs to look out for. I look forward to bringing my clients along on the journey with me as we raise the profile of behavioural finance and educate people as to what it is and exactly how it can help. Making this a part of the onboarding process with new clients is a great place to start. The advisers who commit to taking it up, embed it in their working practices and educate their clients of the tangible benefits are the ones most likely to see it bring success.

Designing the right client experiences

One of the ways to make behavioural finance relevant is to promote how it can have a real and positive effect on people’s lives. By designing the right experiences, informed by the insights of behavioural finance, we can help our clients make consistently great decisions.

US financial adviser, Mitch Anthony says that successful long-term relationships succeed when we concentrate on how we make our clients feel. He put together a list of six key concepts that he believes financial planners and clients should focus on: organisation; accountability; objectivity; proactivity; education; and partnership. I recently wrote about his thinking and how it can help us in creating client experiences that will strengthen and nourish the adviser-client relationship.

Creating a contract

Once a client has become familiar with the potential pitfalls of letting emotional behaviour influence their investment decisions, advisers can start to work out how to address this for the good of their financial plans. With a knowledge of behavioural biases, the clients could sit down with the adviser and draw up a contract of their relationship, highlighting the potential biases and committing to avoiding them in future. If and when clients and advisers come to a point in their relationship where the adviser feels the client is about to make a decision which isn’t in their best or long-term interests, they can revisit the contract to remind themselves of the agreement they made together. This approach is as useful for keeping advisers in check and focused on the long-term goals as it is for reminding clients of their ambitions.

Adapting the style of reporting to the length of the investment cycle

While the best general advice about investing is not to tinker with the portfolio and let the markets do their work over the long term, it is still important as advisers that we monitor the progress of the investments on a regular basis. As part of our service to clients, once we have structured their portfolio and agreed on an investment plan we will meet with them on an agreed schedule to report back on how their investments have performed in the intervening period.

However, if a client has recently put in place a 20-year investment plan for their retirement, is it appropriate or necessary to meet with them every six months to assess progress and growth? This could encourage short-term alterations to the portfolio which may have a damaging effect on returns. Perhaps in the earlier years of a long-term cycle, the focus should be almost entirely forward-looking, towards the ideal future lifestyle: ensuring they’re spending as they should be, that their lifestyle goals or current situation haven’t changed, and that they are still on track to achieve their ambitions. This would be a healthier approach than looking back and obsessing unnecessarily and unhelpfully on short-term returns when there’s still a long way yet for the investment to go.

Constructing a portfolio according to behavioural psychology

With an understanding that investors can sometimes behave in ways that might be at odds with their long-term investing success, we could explore the question of whether we should structure a client’s portfolio accordingly. We know that the approach that is most likely to result in investing success is to put a long-term plan in place and to allow the portfolio to do its work over time. However, nowadays, 24-hour news and the huge availability of information has made investors more hands-on and keen to tweak and amend their portfolio in the light of every short-term change in the investing climate. Our analysis of behavioural biases will help to identify those clients who have more composure in times of market stress, and those who are likely to make bad decisions under duress. An adviser will need to make a judgment call about the type of portfolio that is best suited to each client.

For example, in reaction to the UK’s upcoming exit from the European Union, a client may ask to remove some risk from the portfolio in anticipation of this unknown quantity. We would advise against knee-jerk reaction, and reassure them that events like Brexit have already been factored in and can be absorbed by the portfolio with little or no change to the plan, but the client may still insist.

However, if at the beginning of the relationship we had structured their portfolio in the knowledge that in an environment of mass availability of information the client is likely to want to react to higher risk options, could we have mitigated this? It would mean putting together a portfolio with investments of lower risk which are less likely to cause short-term panic or knee-jerk reactions. The goal is that their portfolio remains longer invested in the market. There will be ups and downs but the benefits of compounding over time will outweigh the blips, leading to a healthier return at the end of the cycle.

An exciting future

An understanding of behavioural finance can change our approach to investing and points to an exciting future for us all. It’s an area which is still in its relative infancy and I’m confident that there’s so much more to come.

Our aim is to help you target your ambitions and create your ideal financial lifestyle. Harnessing the insights of behavioural finance gives us the potential to supercharge the power of financial planning to help you achieve your dreams.

I hope you’ve enjoyed reading this series as much as I have enjoyed writing it. If you would like to discuss how knowledge of behavioural finance can help you achieve your financial lifestyle plans, please get in touch.

This document is marketing material for a retail audience and does not constitute advice or recommendations. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amount originally invested.