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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 that fact.
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 like micro loans.
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 now.
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.
Views are his own)
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