This article gets into the details of behavioural economics and how it applies to investments and financial decisions of all kinds.
Behavioural economics may once have been an obscure topic outside academia but it is now quite well understood in areas such as investment and finance. Humans can become over confident or unduly pessimistic, or attribute to skill what in fact was caused by luck. And such cognitive biases are, so it is argued, hardwired from pre-history. But self-knowledge can also help humans overcome such biases, maybe, and avoid falling into some of the traps one sees in investment behaviour.
A consultant in the wealth management industry, Dennis Harhalakis writes here about some of the uses of behavioural economics that can be applied to wealth management. Harhalakis has worked for firms such as Gulland Padfield and CTBC Bank. The editors of this news service are pleased to share these views with readers and invite responses. They can email firstname.lastname@example.org
The ability to quickly absorb billions of information points from your environment and then have an accurate, corresponding response ready within seconds is an incredibly valuable tool. This is our reptilian brain, which manages the “fight or flight” response, helped keep us alive over millennia, and still drives about 25 per cent of our behaviour. As humans evolved and the brain had more space to grow, we developed our mammalian or emotional brains. The extra space is used to store memories and the emotions associated with those memories. The responses produced by the reptilian and emotional brains are incredibly fast because they carry information subconsciously and do not pass through the thinking brain; together they make up our reflexes and drive up to 95 per cent of our behaviour. The thinking brain developed last and controls cognition, reasoning, language and higher intelligence.
This brain consists of the frontal lobes or neocortex and, while it occupies about 80 per cent of the overall brain surface area and does most of the thinking, it only drives about 5 per cent of our behaviour. In reality, the three regions of the brain do not operate independently; instead, primal, emotional and rational mental activities are the product of neural activity in more than one of the three regions, and their collective energy creates human experience .
Why does this matter? As behavioural economics has shown, our conscious decision making processes have flaws and biases. From an economic perspective, we don’t act rationally a lot of the time and this is primarily down to a disconnect between our evolution and our environment. There is a gap between how our reflexive brain responds and what we need our reflective brains to do. This reflexive ability, which still drives up to 95 per cent of our behaviour, has been incredibly useful to us over the years. But in situations where logic and reasoning are necessary, it serves us less well.
In the context of wealth management this creates a number of issues. Human beings are primarily comfort seeking, and in situations of conscious decision making, this results in an underlying tension between the right answer and the comfortable answer. This can be thought of as the comfort gap.
This gap is often filled by procrastination, the inability to make a decision. Our brains are wired for reflexive decision making and the bigger the gap, the more we reach for the comfortable action; the closer the right answer is to the comfortable answer, the easier it is to make a decision. In addition, making a decision can appear to reduce our mental and psychological flexibility. In other words, once we’ve made a decision we’re stuck with it, and this also increases our discomfort. In some situations the comfort gap can be filled by over-activity or unnecessary action - once we have made a decision, we find it difficult to leave things alone. As Greg Davies from Oxford Risk explains, the comfort gap is highest when:
• The outcome is in the future;
• The decision is highly complex;
• The decision is based on trading off abstract notions – e.g. hypothetical returns/futures; and
• The decision is infrequent and you cannot easily build up experience.
All these factors are present in financial decision planning, thus making it one of the most challenging processes we can go through. In addition, when dealing with money, our relationship is primarily emotional and so our first responses come from our emotional brain. In order to use our thinking brains, we have to get past these reflexive responses and the emotions associated with them.
Thus, when looked at from the viewpoint of how our brains operate, we can see how hard it is to use only logic and reasoning these situations:
As Wealth Managers, we need to do more than construct efficient portfolios. We need to help our clients to close the comfort gap and design our systems and processes to take into account the flaws in our decision making processes. We need to help our client to understand that:
• The financial planning process is not what our brains were primarily designed for;
• Dealing with money triggers emotional responses;
• ‘Buying’ comfort sacrifices financial returns; and
• Managing wealth is a journey.
We should always remember that “the primary reason that investors fail to attain good returns is not a lack of knowledge of a good solution, but the lack of the emotional capacity to enact it” .
 Greg Davies, Antonia Lim http://www.centapse.com/wp-content/uploads/2016/10/Dont-let-the-best-be-the-enemy-of-the-achievable-2014.pdf