Badly behaved finance

Last year was the worst year for mainstream investors since 2008. As 2019 looms ahead, investors, asset managers and advisers work overtime to make sense of why it all happened as it did. It also involves its fair share of personal and psychological soul-searching.

We’re all predictably irrational. Evolution gave us a set of reflexes for fast decision-making that override our thought processes, largely because these reflexive responses have strong emotive content.

These hard-wired psychological biases are something advisers and managers simply must understand if they’re to be able to guide clients to good solutions, because they’re the real source of the fear-greed dynamic that drives financial markets.

The instincts that helped us avoid being eaten by the sabre-toothed tiger evolved to include overrides, just like what happens when you jump out of the way of a bus before you start to think. But we apply gut-driven heuristics (rules of thumb) to all sorts of things that didn’t exist on the African savannah, including stock markets, where relying on instinctive-emotive responses can result in being skinned rather than being saved.

Man is naturally poor at assessing probabilities, instead relying on gut responses to decide whether something’s risky. We use single reference points (useful for running away from danger) to assess complex situations, where they just don’t work. We value what we’ve got far higher than what we haven’t (on the savannah, the meal in the hand was worth many meals in the bush), so the ‘endowment effect’ biases our investment decisions. And so on.

However hard we try to be rational, we still get carried along by the wave.

So, for financial advisers and managers, the behavioural finance problems are twofold. One: identifying biases in your clients and trying to prevent them from severely damaging the client’s interests. Two: trying to identify areas in which you are being affected by herding and other reality-bending mental quirks.

Behavioural finance isn’t some new box of tricks nor one that contains any magic bullets. Charlie Munger, Warren Buffett’s long-term partner at Berkshire Hathaway, has been saying for the last 40 years that identifying your own biases and correcting them is the most difficult and rewarding thing you can do as an investor.

Before tackling that issue, my advice for you is to assess your own ‘irrationality’ and work out what you have to do to correct it. Then think about how you can apply that to your own adviser or manager. You’ll probably discover that many of them are less irrational than you are.

This article is intended to provide a general review of certain topics and its purpose is to inform but NOT to recommend or support any specific course of action.

By Raoul Ruiz Martinez

Raoul Ruiz Martinez is a resident and independent consultant for Finesco Financial Services Ltd., Glasgow and advises clients on private financial matters in both the UK and throughout Europe under the MiFID regulation. Finesco Financial Services Ltd is authorised and regulated by the Financial Conduct Authority (FCA). Some of the services provided are not regulated by the FCA because they are not included within the Financial Services and Markets Act 2000. | 289 561 333