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Applying Behavioural Finance to the Consumer Investment Market #2a: Failings of non-existent suitability 1 – behavioural capacity

February 25, 2021
Suitability

This is the third post in a series giving our response to the FCA’s Call for Input on how to apply behavioural finance to help people make engaged investment choices more comfortably and confidently, and what role regulations can play in helping that to happen.

The series highlights four broad areas where better application of behavioural-finance insights can lead to better investor outcomes.

This post covers aspects that should form part of a suitability process, but are currently overlooked, starting with behavioural capacity – an investor’s emotional ability to take investment risk.

The full series (additional links to be added later) is:

Introducing Behavioural Capacity: suitability’s overlooked human side

The FCA asked: Have we prioritised the right issues and questions? Are there other things you think we should be looking at?

One thing stands out.

Underlying the 39 questions in the FCA’s Call for Input is a product-centric view of retail investing. This is suitability at point of sale, not suitability of ownership. Yet investing – as the FCA would be the first to tell us – is a long-term, lifestyle-centric, journey, not a short-term product-centric event.

It’s a strange situation when advisers are required to subject clients to an often off-puttingly onerous (and therefore counterproductive) up-front ‘know your client’ process, only to then be free to act as if people turn into robots when they start to own investments.

There is an imbalance in suitability between helping investors understand investment management and helping advisers understand investor management.

In the previous post in this series, we looked at the parts of the suitability process that were acknowledged as important, but typically poorly executed, for example unscientific approaches to Risk Tolerance, inadequate and undynamic approaches to Risk Capacity and the lack of a consistent method for combining the two.

In this post, we look at something that’s just as important, but overlooked completely: Behavioural Capacity – the missing third pillar of a human-centric suitability process.

What makes an investment selection suitable? Advisers and regulators agree that it’s about matching the risk an investor is both willing and able to take with that actually being taken.

An investor’s willingness is represented by Risk Tolerance.

What about ability?

Ability is primarily about financial circumstances. What is it that’s being risked, considering the investor’s overall picture? How reliant is someone on their investments to fund their lifestyle? This calls for a quantified and dynamic measure of Risk Capacity – an investor’s ability to fund future financial commitments from their wealth, and therefore their ability to take risk with this wealth without jeopardising these commitments.

However, ability doesn’t stop there. In addition to this financial ability to take risk, each investor also has an emotional ability to take risk: a Behavioural Capacity that determines how best to interact with investments to ensure ongoing comfort with the risk being taken.

It doesn’t matter how good a plan is if the person it’s written for doesn’t stick to it, or feels anxious doing so. Indeed, the theoretically ‘perfect’ portfolio could be the very spark for some distinctly imperfect behaviours. Emotional ability is not about financial circumstances, but financial personality.

Zombie suitability: sleepwalking into trouble

Behavioural Capacity recognises that investors are humans… throughout the whole time they own investments. In the absence of an assessment of emotional ability, you don’t have human suitability, you have zombie suitability – suitability for something that looks like a human on the outside, but which relies on it having no consciousness on the inside.

In philosophy, a zombie is a hypothetical being that is physically identical to and indistinguishable from a normal person but does not have conscious experience. It’s exactly what a lot of advice acts like it’s dealing with when it fails to consider the behavioural factors influencing suitability.

At present, the typical reality across most of the industry involves excessive focus on Risk Tolerance; muddled and inadequate focus on Risk Capacity; and very little consideration at all of Behavioural Capacity (despite this being catastrophic in many cases if ignored).

Behavioural finance makes finance more relevant to real-life. It bridges the gap between the mathematically optimal model village of the textbook and the more practicable, but more psychologically complex world where humans live, in all their haphazard glory.

The awareness of behavioural concepts within financial advice has come a long way since I founded the banking world’s first behavioural finance team at Barclays in 2006. Conferences are dedicated to its discussion. Kahneman and Thaler inhabit adviser bookshelves. The FCA has a Behavioural Economics and Data Science Unit. However, despite these advancements, I’m still often asked questions along the lines of: ‘This is all interesting and insightful, but how do I, as an adviser/investor, apply these ideas to help my clients? What does behavioural finance actually look like in real life?’

Behavioural finance in real life is about moving behavioural finance from the fringe to the core of decision-making systems. It’s about blending the best of both worlds. It’s about using ‘decision prosthetics’: tools that help guide humans towards a better, engaged, decision, not make it for them. It’s about providing tools to make both advisers and clients more consistently the best versions of themselves. It’s about making these tools as integral to the investment process as an artificial limb to its host: better built-in than bolted on.

While it’s good that behavioural finance is being talked about, talk is cheap, and suitability failures based on cheap talk can be extremely expensive.

Investor management is often just as, if not more, important than investment management. The consequences of lessons learned, or mistakes avoided, can compound even more dramatically than financial returns. Investment-management solutions – baking behaviours into the long-term risk level of a portfolio – are usually an unnecessarily costly way to provide an investor with comfort, relative to investor-management ones of tweaking decision-making and communication frameworks.

The FCA has rightly identified the importance of consumers’ behavioural traits as factors hindering good decision-making and understanding, as well as the importance of behavioural finance, behavioural design, and technology in improving decision-making and consumer outcomes.

However, there seems to be little consideration, either in this Call for Input, or in suitability regulation generally, of how differences in consumers’ behavioural traits may actually substantially change the suitable solution and the costs to investors of not considering these factors.

Whilst suitable advice requires consideration of investors’ Risk Tolerance (which, as per our previous post, is frequently very poorly measured), in-the-moment risk attitudes are multi-dimensional and highly context dependent.

Many investors, for example, have levels of Composure which may differ considerably from their long-term Risk Tolerance (their willingness to trade-off risk and return of long-term outcomes). Thus, the investment solution that is suitable for their potentially high long-term Risk Tolerance may not be suitable when also considering their low Composure.

This need not change their long-term portfolio solution, but these low Composure investors should certainly be treated differently along the investment journey – they are most in danger of acting in response to emotional impulses along the journey, despite being in the portfolio suitable for their long-term willingness and financial ability to take risk, potentially at great cost.

In the next post, we’ll look at the consequences of treating humans like zombies in three practical scenarios: pension transfers, ESG investing, and adviser noise.

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