THE CONCEPT OF behavioural finance has risen to prominence in recent years, but what does it actually mean? We speak to two experts in the field: Joe Wiggins, author of The Intelligent Fund Manager, and Tracey Reddings of St James’s Place.
Can you explain what behavioural finance means to those who aren’t aware?
JW: It is easy to dismiss behavioural finance as an arcane, academic subject, but it is not – it is fundamental to meeting our investing goals. At its heart, behavioural finance is about the gap between what we should do – following our rational intentions – and what we actually do – which is often something quite different. This gap can be large and incredibly costly.
TR: As Joe says, behavioural finance is the gap between your financial goals and the emotional – or irrational – behaviours any one of us are capable of taking, which are not supportive of your long-term financial strategy. From an advisor perspective, understanding behavioural biases is critical to our roles, because while agreeing a financial plan with your client is the easy part; having them stay the course during market volatility is the real challenge. For me, working with clients’ behavioural biases has three components: taking time to understand your clients’ goals and triggers; reassurance where needed; and building their trust.
Is behavioural finance only relevant for professional investors?
JW: Not at all, it is critical for everyone making investments. If we don’t think about our own behaviour then we are liable to make consistent mistakes, which can compound over time into a painful financial cost. This doesn’t mean we need to have a forensic knowledge of behavioural finance, but simply understand where investors tend to go astray and have a plan for dealing with that.
TR: Definitely not. Behavioural biases – and how they affect our long- and short-term decisions towards our finances – affect everyone. I chose to complement my technical financial credentials with a Coaching qualification, because it’s essential than anyone handling clients’ money understands their personal psychology around money.
By this I mean being able to help them understand what their true goals are, their financial trigger points, and where they stem from. With this information you are better equipped to ask the right questions, have the right client-advisor dialogue long-term and help them mitigate emotional-based decisions in times of volatility, where all our behavioural biases tend to be exacerbated.
Behavioural finance is about the gap between what we should do and what we actually do
Can you give an example of a behavioural issue that has major influence on investors?
JW: There are so many issues that investors must deal with, but perhaps the most pernicious is short-termism. Worrying about near-term risks has been very useful to humans from an evolutionary perspective – it helped us to survive – but it is terrible for being a successful long-term investor. We tend to focus far too much on what is happening in financial markets right now and forget our long-term time goals.
TR: Right now , I’d pick prolonged market volatility. The last two years have been the first time since the global financial crisis that we’ve seen this level of fear around staying invested. Everyone’s mettle is being tested, and the real difference, since say March 2020 when markets took a dramatic downward spike, is the longevity of the downward trajectory that we are currently experiencing.
The current situation brings with it the opportunity to have more dynamic conversations with your clients on the perceived risks on their portfolios and have them think more deeply about what their long-term goals are, and whether they are still able to meet them based on the current situation, or if there are adjustments that need to be made – and those that don’t involve liquidating your investments, which will hurt you in the end. This goes back to the three pillars of understanding, reassurance, and trust.
What role does financial advice have to play?
JW: The amount of value the financial advisers can create for their clients by providing guidance about investment decision making and behaviour seems to be greatly understated. The cost of one behavioural mistake – such as moving our portfolio to cash at the trough of a bear market – can outweigh any other investment decision we make. Advice that helps us avoid such situations can be transformative.
TR: The last time I saw smart investors make poor snap decisions was during the financial crisis, and the impact that fear had around how we managed our portfolios. Advisors play a crucial role in helping clients remain steadfast during these times, by proving reassurance of the long-term efficiency of staying invested.
Remind clients that you are riding the roller-coaster with them. An effective tool is scenario planning using cash flow forecasting – helping to reassure that you are OK, and on track to meet your goals in the short, medium, and long term. When clients can understand what their investments look like and measure against cash – subject to tax and inflation – and just how detrimental it is to liquidate, you can use your role to keep a strong hand on the tiller and weather the storm with them.
For more investment advice, see sjp.co.uk