INSUBCONTINENT EXCLUSIVE:
By Stephen WendelIn my last column, I wrote about what behavioural finance is, and how it’s been applied by our industry over time
Here, we’ll look the tools available to you, how they are being used, and what the future might hold for behavioural finance.
Where
behavioural finance is being applied now, and howBehavioural finance applications are growing across the industry
In the west, Barclays appears to have been the earliest mover, building a behavioural team over 11 years ago
Since then, behavioural researchers have found a home with companies like Merrill Lynch, Allianz, UBS, Commonwealth Bank, Morningstar, and
recently, at the two colossuses in the field, Blackrock and Vanguard.
Smaller companies like Betterment also conduct applied behavioural
work to help their users stay on track
Each of these efforts focuses on how to help investors succeed, and the industry professionals that support them.
At the same time, we also
find that there is significant growth in different types of tools available to help investors
There are at least four distinct approaches at work in today’s environment, each of which can help overcome or avoid individual biases:
nudges, automation, heuristics, and coaching.
Nudges include techniques like age progression
In a research done by Hale Hershfield, the subjects who were shown their own age-progressed faces in a collaborative virtual environment,
allocated twice the amount to retirement plan compared with subjects who were shown their current self-image
Another way to nudge retirement planning behaviour is to display future wealth as a monthly income instead of a lumpsum (the former is often
more effective in encouraging people to save and invest).Automation includes automatic enrolment for retirement plans, and
behaviourally-savvy rules-based investing
In a study done in 2004, Richard Thaler found that the enrolment spur for retirement plans increased by 15-20 per cent when employees were
auto-enrolled with the option to opt out compared with employees who were asked for voluntary participation.The third approach, heuristics,
focuses on using research-driven rules of thumb to make quick decisions
Analyst ratings and star ratings for different funds based on the principles of fundamental analysis and value-driven investing can be used
as good examples of research-driven heuristics by professionals
Another good example of a positive heuristic would be encouraging people to pay off credit card debt with a payment of at least twice their
minimum balance each month
It’s a simple rule to remember that aids the user and doesn’t require detailed financial analysis.Behavioural coaching is a more
hands-on approach where an adviser or other professional works with the client to address unhealthy money habits or behaviours with a deeper
understanding of their idiosyncratic psychology
One of the reasons these new efforts are so exciting is that they can help counteract broader societal incentives to overspend, underinvest,
or act rashly in the face of market changes.The future is exciting, but not yet integratedWhat does the future of behavioural finance look
like for practitioners? Behavioural finance is rapidly growing in prominence and practice, and there are both risks and benefits inherent in
The most obvious risk lies in unethical applications of the research
Questionable behavioural applications have been in limelight at companies such as Uber and Facebook in the recent past
These companies have been accused of exploiting people’s biases for profits and could cast all behavioural science (including behavioural
finance) in a negative light
If behavioural finance has taught us anything in the last decades, it’s that negative outcomes are often far more vivid and powerful than
positive ones.
Secondly, there is still a common tendency in the field to use behavioural biases as “a set of parlour tricks” (in the
words of fellow practitioner and author Daniel Crosby): showing that people do foolish things, and then convincing them to buy a product
Without a systematic analysis of how to help investors succeed, these parlour tricks are destined to disappoint.
Despite these risks, we
believe that behavioural finance will continue to grow, especially as successes in the field show its power to benefit investors
Behavioural finance has the advantage of being grounded in formal experiments, aka “randomised control trials”.
They are the gold
standard for testing hypothesises and determining the impact, for everything from new medications to international development techniques
We’ve already seen behavioural finance’s compelling evidence in academic studies, and increasingly it is showing up in practical
experiments in the field.
The intersection between behavioural finance and practice can been seen in terms of four distinct themes:
cataloguing investor biases, arbitraging market anomalies, developing tools to avoid and overcome these biases, and exploiting people’s
biases for profit.
The process of enumerating investor biases is unlikely to continue at scale
While there is nuance at the margins, our central picture of how the mind works and the mistakes that investors make is clear enough to act
The marginal value of identifying new biases is simply limited.
The second area, exploiting behavioural market anomalies, is both tricky to
implement and cannot be both widespread and successful
Deceptive ads, opaque products, and people hyping hot stocks on TV will sadly continue, if part of the industry focuses on short term
profits instead of long-term investor outcomes.
The true value though, both for investors and the industry that supports them, lies in
practical techniques for overcoming investor biases
Long-term incentives are aligned: the individual investor grows wealth, while the industry increases asset under management
This is an area in which financial companies are increasingly investing and building up their internal capacity
Behavioural finance can and should be a vital tool to leverage research and software, in the broader industry, to help investors reach their
financial goals.
(Stephen Wendel is Head of Behavioural Science at Morningstar