Or put it another way: humility is smart. Knowing your biases and the dangers of falling prey to investor crazes and false confidence is something that marks out the wise investor from the fad-chaser, argue the teachers of a growing field known as behavioural finance.

In recent decades, many economics and finance textbooks contained models of human behaviour which, for all their mathematical elegance, seemed to have little connection to reality. These models included the idea of people as perfectly rational, all-knowing actors working in a world of “perfect competition”. Unfortunately, because the real world is full of fallible people who are unavoidably ignorant of many things, it is easy to despair and assume that competition and investment is a baffling game with potential traps. But understanding behavioural issues can help a wealth manager still achieve valuable gains and avoid some, if not all, mistakes, say behaviour finance experts.

“It is very hard to predict the future, but we can, if we try to avoid certain behaviours, get better at it,” Yaz Gulnur Muradoglu, Professor of Finance at the Cass Business School in London, told this publication recently.

Better prediction will be music to the ears of wealth managers and clients who, for example, suffered as developed markets’ stocks crashed by around 40 per cent in 2008 (source: MSCI), or who got burned by the end of the dotcom boom in 2000.

Among the biases Professor Muradoglu illustrates is “hindsight bias”. This is a particularly serious kind of bias in economics. It can lead to a person convincing him or herself that a lucky decision was something about which he or she had been certain all along, she said, giving the example of an interest rate increase or a profit figure. 

“People are not trained to reveal they are uncertain about things. We are not used to revealing the uncertainties that we have,” she said.

Another bias borne out of reflexive caution towards the unknown is “home bias” (as in the case of investors choosing their home markets and ignoring foreign ones or those in unfamiliar sectors). As a result, investors should broaden their horizons. There are signs that this is happening: there is a great deal more commentary about emerging and "frontier" market investing than there was, say, 30 years ago.

Professor Muradoglu argues that any process of achieving self-knowledge and avoidance of bias must involve tracking how one felt leading up to a decision, checking the data carefully, and where possible, writing this down.

Also, establishing certain rules can be useful, since biases can be held so unwittingly that a person might not realise they are falling into a trap. For instance, consider the rule of never investing in a product where the seller does not give certain information. A good rule for any wealth manager, Professor Muradoglu said, is to ask analysts how they arrive at decisions, and give examples. (It would have spared some wealth managers’ clients had they checked up on the processes of Bernard Madoff, for instance).

Rising profile

Behavioural finance may not yet have fully entered the mainstream, but its rising profile demonstrates how some of the earlier orthodoxies that once held sway in business schools and universities are under challenge. As more is learned about how the human brain operates – drawing from fields such as evolutionary psychology – academics are finding new patterns of observable behaviours that apply to finance.

Professor Muragoglu, a native of Turkey with an impressive academic biography, has certainly noticed an increase in interest during her nine years at Cass. Its rising profile mirrors that of other “non-orthodox” economic schools such as “Austrian economics” (a body of thought, originating in 19^th Century Vienna, that stresses issues such as competition as a knowledge-discovery process and that entrepreneurs act amid great uncertainties and only partial information.)

“By nature, it is not in the mainstream because it challenges the main ideas. But it is a field that is growing,” Professor Muradoglu said.

A number of firms are now incorporating behavioural thinking into their strategy. One such firm is Thurleigh Investors, a UK firm; Barclays Wealth has also embraced some of these insights into its psychometric tests of clients to get a better read on what clients want. Another firm that has used behavioural economics ideas is Investec Asset Management. One of IAM’s fund managers, Alastair Mundy, has argued that investors should heed behavioural issues to avoid buying vehicles such as structured products that may play on certain fears.

And judging by the vast number of books on the shelves in Professor Muradoglu's office, behavioural finance is now big academic business. A number of universities and business schools run classes on it or have academic staff who teach and write about it, such as at Cass, New York University's Leonard Stern School of Business, and Wharton. The field has its critics: at the University of Chicago, for example, Eugene Fama, who is a leading proponent of what is called the "efficient market hypothesis", has been quoted making sharp criticisms of behavioural finance. (Broadly, the EMH states that prices in markets discount all known information, a view challenged by behavioural ideas.)

Professor Muradoglu says she has definitely seen a rise in requests for her advice, a process given an added jolt by the financial turmoil.

“The demand for me has grown since the credit crisis, from fund managers, professional institutions and other groups; they want to hear a different point of view,” she said.

Professor Muradoglu is working with a fund in New York to look at the sort of biases that arise with forecasts. “They want me to improve forecasting among their own analysts. They also want to improve the working environment of their analysts. This fund has a four-to-five-year time horizon,” she said. 

Time will tell whether this fund, like other institutions embracing behavioural finance, will enjoy improved fortunes. By watching our biases, the argument goes, we have a better chance of hitting our targets. Clint’s Inspector Callahan would approve.

(To view a long article via the Wharton university's site, looking at debates about behavioural finance and its critics, click here).