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Behavioral Finance Tested By Extraordinary Times

TOM BURROUGHES, GROUP EDITOR April 30, 2020

The discipline of behavioral finance has evolved over recent years, and the massive economic changes wrought by COVID-19 give examples of how the insights are being put to work in the wealth management industry. There is still plenty of room for development and education, people working in the field say.

Human emotions are being pulled about a lot at the moment, and no wonder. Consider the following: Market slides, economic lockdowns and angry words exchanged between China and much of the rest of the world; daily headlines of COVID-19 deaths, rising unemployment and canceled cancer operations.

The upheavals caused by the pandemic have hit people across a number of fronts, and one obvious result has been the heavy fall in market indices since the start of the year. The worst of the rout saw broad indices fall by as much as 30 per cent or more. As of the time of writing, indices are down by around 15 per cent. That’s not as dramatic as the 22 per cent fall on the October 19, 1987 stock market slump on a single day. Or, to take another example, the dotcom era saw stocks crash by almost 78 per cent from their peak. But even if markets recover eventually, investors had a rude reminder of how fast things can move. And because of that, the lessons from a growing discipline known as behavioral finance remain hugely relevant.

Behavioral finance tries to delve into the real drivers of human conduct to understand events such as market booms and busts, and why people can allow biases to lead them into mistakes and other issues.

A hope that some BF advocates have is that advisors and their clients will put these insights to work, learning to be more resilient during tough times and avoid panic and costly errors. It turns out that the behavioral finance revolution has a while to run before it becomes part of investors’ mental furniture, however.

“A lot of advisors could have been better prepared than they are,” Greg B Davies, PhD, who works Oxford Risk, which delivers insights drawn from behavioral finance for the industry, told this news service.

Hopefully the COVID-19 saga will give behavioral finance a big push, said Davies, who before working at Oxford Risk had created his own consulting firm Centapse, and prior to that, worked for a decade at Barclays, heading its behavioral finance team.

Davies argues that while the pandemic has shocked people, it should not be viewed as a “black swan” event, because the world has been shaken already by health crises such as SARS, Ebola and Swine Flu.

Across the Atlantic, Jon Blau of Fusion Family Wealth, a US wealth manager, said that behavioral finance “is at the core of our being as a business”.

“We specialize in helping investors learn to make rational decisions about money under conditions of
uncertainty – which is all the time.” ….”Certainty doesn’t exist anywhere in nature”,” he said. In terms of how to prepare clients for a shock, one should think of it as a lifeboat drill. “You need to know where all the safety equipment is long before the bow goes into the water.”

Be prepared

The idea of being prepared, of learning how to be “anti-fragile” (to borrow a term from the writer Nicholas Taleb), is an important BF building block.

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“You need to prepare yourself in advance. You need a contingency plan. Understand your financial personality,” Davies said.

The tools and approaches that people should have considered in the good times to prepare for a crisis aren’t going to be of much use if they haven’t prepared first.

Davies mentioned parallels with how the military thinks about preparing for stressed situations, such as the idea of “redundancy”, of having people used to doing other persons’ jobs if they need to. A problem is that this sort of “redundancy” understanding does not feature in a modern, growing free market economy, with its focus on efficiency and a complex division of labor.

The key question that many investors and advisors will have is how to use these insights for their advantage.

“Anyone who is still accumulating wealth has an advantage. They are not in a hurry and can use this to their benefit,” Davies said.

If people are still earning they are in a position to invest at lower valuations. Many professional investors, on the other hand, are forced to trade, so are in some ways at a disadvantage, he continued.

Another pointer is not to watch short-term market moves but concentrate on longer-term goals. Shut out the “noise”, Davies argues.

Fusion’s Blau concurs.

Blau highlighted the mistake of investors getting out of a down-market and thereby missing out on any rally, which given long term outperformance of equities is a classic mistake.

“The question to ask is `what’s the price one needs to pay to benefit from equity investing’ – volatility!” he said.

He said investors make three major errors: Conflating risk with volatility; sellers of businesses think the task of wealth management is to preserve capital, but ignore the falling purchasing power of money and people think differently about buying equities than they do when buying and selling decisions around every other item.

“Investing successfully is a big challenge….there is a tug of war between one’s faith in the future and fear of it,” Blau added.

Psychology

The discipline harnesses what we know about human psychology to understand that the decisions people make with savings, investments and spending aren’t as coolly rational and objective as one might think. Humans don’t, so the argument goes, start off in life with a mental “blank slate” but instead carry habits and tendencies that are products of millions of years of human evolution. (Some of these notions can be controversial – the field known as evolutionary psychology, drawing on ideas from Darwin and others, can carry political implications such as male/ female differences.)

It is worth pointing out that it doesn’t necessarily mean that when a person thinks that they are acting rationally they not doing so, or that, on introspection, they have acted rationally and chosen a course of action which is an illusion, like something out of The Matrix movie. Rather, practitioners in this area generally seem to argue that the more
we know about how we think, and how we can be biased, that paradoxically the more rational our choices will ultimately be. For example, a person who knows that they have a short temper in certain situations might be more careful about avoiding such situations; a person with an addictive personality might take care to avoid getting into environments where temptations exist, and so on.

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Terms

The field comes as one might expect with a lot of terms, some of which explain ideas that seem obvious once they are grasped. For example, there is what is called “anchoring bias” – the trait of relying on the first piece of information that is encountered as a reference point (or “anchor”). Another is “confirmation bias” – a term relating to the tendency people have to listen to those who agree with them. “Framing bias”, in turn, is about how people judge information by how it is presented; a change in how a problem was framed can cause investors to alter how they reach a conclusion.

There’s “herding” – we are hard-wired to form crowds – hence events such as market booms and mass political movements. “Hindsight bias” explains how people don’t realise they make mistakes and assume that after something happened, such as a big spike in the equity market, we knew it all along. So the list goes on to include notions such as “illusion of control”, ie the mistaken idea that people have more influence over events than they really do (as in the idea that people can consistently beat a market). Other concepts include “loss aversion” (people tend to hate losses more than they enjoy commensurate gains); “representative bias” (judging matters by appearance), and “self-attribution bias” (thinking that good outcomes prove how clever one is, not thinking of luck. Or, perhaps, arrogance.)

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