The area known as behavioural finance continues to develop in aiding investors in avoiding the traps that their biases can lead them into, argues M&G.

WealthBriefingAsia recently met Andrew Hendry, managing director of M&G Investments Asia, to listen to the case for using behavioural finance in the investment process. Much ink has been spilt in recent years about what this area means and how its insights can be exploited. In a nutshell, it seeks to probe how humans are not as coldly rational as many conventional models of economics would have us believe. The persistence of market crashes and booms – as demonstrated by such renowned examples as the Dutch tulip mania or the more recent dotcom boom, are evidence of that.

The discipline of understanding why we make mistakes, such as attributing to smart thinking what in fact is down to luck, has come on leaps and bounds in recent years. A number of firms, such as Barclays, make great play of how they use insights of BH to help drive investment decisions. A key issue, of course, is putting these insights to work so that, over time, clients are better off than they would otherwise be. So what is Hendry’s take on all this?

To begin with, Hendry is warm on the idea that people can adjust their thinking to embrace behaviour finance ideas in investing.

At present, Hendry says that BF is not being widely used in the investment process with the exception of some hedge funds that are said to use such principles during specific market episodes. Recent moves by major banking groups, however, may see behavioural finance models become more mainstream.

What is clear, according to Hendry’s research, is that raw human nature takes over when it comes to investing. Herd mentality, selective attention bias and personal emotions subconsciously kick in. This is where BF can curb knee jerk responses and aid investors allocate their capital efficiently, he says.

It is worth pointing out that behavioural finance isn’t new to business: In the marketing and sales process, retailers use it to great effect, perhaps cynically, by understanding the flaws of human nature.

Learning about such nature can be a sobering experience about how humans can fool themselves. According to an M&G note about the area, a survey of Swedish people about their driving abilities showed that 77 per cent of respondents thought they were safer than the median (which is logically impossible) and that 60 per cent said they were more skilful. Other data from the M&G note showed that among Asian high net worth individuals (source: LGT Private Banking Report Asia 2012-2013), some 52 per cent of such folk in Singapore hold 52 per cent in cash; 35 per cent of those in Hong Kong do so. Considering that returns on cash will be hammered by inflation, this isn’t wise. The note added that investors are overly-defensive and try – naively – to time markets and fail to see where value lies. All of such errors can be chalked up, in some sense, to behavioural biases.

A common example is where clients are offered special offers on the gimmick of the month, which is free until renewal if one signs up. Using the knowledge of BF, retailers know most people forget or are too lazy to renew or change until they realise much later the standing order charge in the bank statements. It is clear that by nature people are prone to inertia and will not change their default settings.

However for private banks and others to make full use of the technology currently available around BF, there is still a long way to go. It is surely though only a matter of time before an advisor is relying on behavioural finance for the investment process, indeed some private banks are using BF as a risk tool algorithm.

At the very least BF can be a valuable complimentary tool in the investment advisory process. It cannot be dismissed as a gimmick. Watch this space.