Behavioural finance addresses the imbalance in attention between what financial advice is for and whom it is for. To apply behavioural finance effectively requires understanding how investors own investments, not merely what they own. Done well, this can lead to comfortable and confident investors, and better financial outcomes.
- What is behavioural finance?
- What’s the difference between behavioural finance and behavioural economics?
- What are the benefits of applying behavioural finance in financial advice?
- What are the barriers to applying behavioural finance in financial advice?
- What mistakes do wealth managers make when applying behavioural finance in their businesses?
- How should investors’ behavioural traits and tendencies be assessed?
- What do the regulations say about applying behavioural finance in financial advice?
- How can behavioural finance improve access to financial advice?
- How can Oxford Risk’s behavioural suitability tools help you?
What is behavioural finance?
Behavioural finance has become a catch-all term for several topics, from attempts to explain anomalies in stock-price fluctuations at the macro level, to individual investor behaviour at the micro level.
In the context of financial advice, an exact definition of behavioural finance matters far less than the practical application of the techniques, and the core principles they’re based on.
Behavioural finance is built on the understanding that investors are humans, and that far from money causing humans to act like robots, money is one of the most emotional topics there is, thereby rendering most classical approaches to finance redundant, if not dangerous.
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.
Applying behavioural finance to real-life decision-making systems is 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 and overcome behavioural costs of being human. 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. Learn more about measuring both investments and investors in our blog here.
Behavioural finance is about looking beyond a narrow product-centric view of the investment world. It’s about recognising that investment-management solutions to behavioural ‘problems’ – which in effect bake 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.
What’s the difference between behavioural finance and behavioural economics?
For the purposes of improving financial advice, it doesn’t matter.
Anything that researches, and acts to improve how individuals experience their investing journey is welcome; the label doesn’t matter.
What are the benefits of applying behavioural finance in financial advice?
In short, better investor outcomes: not merely better returns, but better returns relative to the individual anxieties experienced along the way.
Just as there is no one-size-fits-all ‘best’ investment, there isn’t an objectively ‘best’ way to report on those investments, a ‘best’ way talk to clients in turbulent markets, or ‘best’ way to structure an investment decision-making process. Knowing the ‘best’ way for each client requires knowing that client in a dynamic, multi-dimensional, contextually sensitive way: a behaviourally conscious way.
The advice industry exists to help investors make wiser choices, by matching them to investments that are suitable for them, given their current and expected future financial situations, their goals, and their financial personalities.
Advice is suitable when it makes (and can evidence!) a good match, and unsuitable when it doesn’t (and cannot).
Behavioural finance is a way of better understanding investors – both their preferences, and their likely reactions to changes in internal or external situations – in a way that improves this match-making process throughout the investing journey. See this post as an example of how a more behaviourally conscious approach could (or could not) lead to a change in the risk level of a portfolio because of a change in market values.
A suitability process rests on:
- accurately assessing each investor’s willingness and ability (both financial and emotional ability) to take investment risk;
- a robust methodology for combining that willingness and ability;
- measuring that overall investor risk in way that matches what is important to investors’ long-term needs; and
- doing so in a way that can be objectively and consistently matched to the risk measurements of available investments.
Classical approaches ignore most of this, by taking a product-centric, rather than a human-centric view of retail investing. This has led to a focus on suitability at point of sale, not suitability of ownership. For example, subjecting clients to an often off-puttingly onerous (and therefore counterproductive) up-front ‘know your client’ process, and then acting as if people become machines when they start to own investments.
Yet investing is a long-term, lifestyle-centric, journey, not a short-term product-centric event.
A point-of-sale focus that fails to consider the behavioural aspects of the journey isn’t suitability for humans, it’s suitability for Zombies – something that looks like a human, but has no internal conscious experience, and just mindlessly pursues brains (or in this case financial returns!). Moreover, as we explain in 'A Wealth Manager’s Guide to Investor Cash Deployment', effective consideration of the investor's journey is also a great way to encourage people to move surplus cash off the sidelines and into the markets. People sit on mountains of cash not because it is secure, but because it feels secure in the moment. A behaviourally conscious approach to helping people get invested recognises and works with this understanding.
What are the barriers to applying behavioural finance in financial advice?
The most common reasons a more behaviourally conscious approach is overlooked or applied inadequately are based on three main beliefs:
- Believing that if it can’t be measured, it doesn’t matter – This leads to downplaying, or ignoring behavioural approaches altogether. It’s very easy to measure financial returns. It’s practically impossible to measure how someone felt about the journey towards those returns, or even the long-term financial consequences of poor short-term decisions not taken because of a well-timed behavioural intervention.
- Believing that meeting the letter of the law is more important than meeting the spirit – Regulations cannot be too prescriptive. However, leaving something open to interpretation (e.g. ‘consider Risk Tolerance’) is to leave it open to misapplication (e.g. asking an investor to self-assess their Risk Tolerance). The spirit of the compliance rules is to understand an investor, not to give the appearance of having done so.
- Believing that bolted-on is as good as built-in – Behavioural techniques are often an afterthought. A process is designed, and then individual ‘biases’ are considered, and standalone measures taken to ‘combat’ them. This can work in certain limited ways, but it’s treating the disease, rather than the patient. Assessing an overall financial personality should be seen not as a nice-to-have addition to a Risk Tolerance score; rather Risk Tolerance should be seen as one component of an overall financial personality.
What mistakes do wealth managers make when applying behavioural finance in their businesses?
Mistakes applying behavioural finance to a suitability process fall into two broad categories: applying something poorly, and failing to apply anything at all.
The most fundamental ask of the suitability regulations is to assess each investor’s willingness and ability to take financial risk.
Willingness is measured by Risk Tolerance. And while this is always done, it is sadly very rarely done well. Assessments commonly use ambiguous or irrelevant questions that confuse investors, or confound Risk Tolerance with other aspects of a financial personality, such as an investor’s Composure or Confidence.
For more on this, see ‘Measuring Risk Tolerance Badly Is As Bad As Not Measuring It At All’.
Financial ability is measured by Risk Capacity. Again, this tends to be done poorly. Failures to properly quantify Risk Capacity, to measure it in a way designed to interact with Risk Tolerance, and to have a sound method for doing that combining are not strictly speaking ‘behavioural’ mistakes, though they are no less fundamental to suitability. Indeed, for most investors, Risk Capacity is a greater determinant of the right level of risk to take than Risk Tolerance.
However, assessing ‘ability’ does not – or rather should not – 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.
The most serious failing is the absence of a systematic and scientifically robust and reliable process for assessing this Behavioural Capacity. Financial ability may be assessed (somehow), but emotional ability is ignored, even though it can easily override the decision-making machinery of even the most financially able.
In addition, common hot-topics like pension transfers, ESG, and adviser ‘noise’ (unjustified inconsistencies in advice between advisers or even within the same adviser) are all hugely behavioural, yet treated as if they’re not. You can find out more about adviser ‘noise’ in our guide: Noise in Financial Advice.
How should investors' behavioural traits and tendencies be assessed?
The most important consideration for any assessment of a human is to see them as a whole. You can – and should – break a situation down for analysis, say into current and future assets, or different dimensions of a personality, but to be effective, these need to feed back into the vision of a whole human, not create that vision in the first place.
You can build a machine up from its component parts, but not a person.
A suitability process is more than a collection of tick-box exercises. It’s not much use measuring Risk Tolerance and Risk Capacity if those two measures don’t talk to each other. Because ultimately it’s not the individual measurements, but their interaction, that determines the suitable level of risk for an investor to take.
Similarly, behavioural traits and tendencies work as a system, not a collection of components. Delivering ‘solutions’ for one tendency, viewed in isolation, could easily be unsuitable in light of an investor’s overall psychological make-up.
The same idea applies to Knowledge and Experience assessments. To be effective in driving better decisions, and better investor outcomes, K&E assessments need to be more principles-based. Cumbersome checklists should be discouraged. They detract from the credibility of the advice process, and have the potentially perverse
consequence of implying that an investor who had not previously traded in a particular instrument should exclude that from a sensible diversified portfolio because of lack of specific experience.
In the long-run, focusing on the ‘efficient’ ticking-off of regulatory requirements in isolation serves neither institutions, nor investors. It’s not good for institutions, which have to keep revisiting their increasingly Frankensteinian processes. And it’s not good for investors, who want to understand, and to be understood, but who are left feeling uneducated and unengaged.
It should go without saying that tests – such as those measuring Risk Tolerance – should be tested. There is extensive academic literature evidencing how – and how not – to conduct a robust, reliable, and repeatable psychometric assessment (as well as the value of psychometric assessments over alternatives in the first place). Yet many measurement approaches are demonstrably flawed when judged against this literature.
This failure of testing also feeds into a failure of investor communication and engagement. We know, for example, that disclosure – especially in the form of bombarding an investor with upfront risk warnings – doesn’t work. It’s been proven time and again to be ineffective, or even off-putting – disengaging people when the very thing we’re trying to do is engage them. And yet it’s still the mainstay of investment ‘education’.
There are more effective measures, for example just-in-time education. This runs counter to the tendency to front-load suitability assessments, but it fits in perfectly with a more dynamic approach to suitability.
Profiling shouldn’t stop when investment starts. It should be married to, not divorced from, the ongoing client relationship, dynamically adjusting to meet changing circumstances.
It’s worth noting, with this talk of engagement, the role of ‘gamification’ techniques in assessing financial personalities. Techniques such as collecting badges signifying completion of certain tasks, the use of leaderboards, or identification with a ‘team’ are great for engagement. But when assessing a psychological trait like Risk Tolerance, gimmicky games don’t test it, they trivialise it. Form should follow function, not replace it. Never gamify at the expense of accuracy. You can read more about the judicious use of gamification in our post ‘Beware Style Over Substance in Risk Profiling’.
What do the regulations say about applying behavioural finance in financial advice?
At their most fundamental level, the regulations exist to ensure that advisers know their clients, because if they didn’t, they wouldn’t know what was suitable for them. The mindset, insights, tools, and techniques of behavioural finance enable advisers to know their clients with a richness unknown to the traditional approaches that treat clients as if they were robots.
There are two sides to any set of laws: the words themselves, and the intentions (or spirit) behind them.
The spirit of financial advisory regulations is clear: to protect clients from bad investments, from unscrupulous salesmen, and from themselves. They aim to increase a client’s comfort and confidence with investing – to arm them with a greater understanding of what they’re investing in, and why.
Comfort and confidence are emotional states, triggered by internal traits colliding with external circumstances. And you don’t manage that by looking through a limited, letter-of-the-law lens.
A focus on the letter of the law can leave advisers feeling like they’re playing a constant game of catch-up. To make matters worse, a focus on the boxes to be ticked rather than the reasons the boxes exist can lead to laws being followed at the expense of meeting the very outputs the laws are there to produce.
Overlooking the spirit of the laws is easy, but dangerous, because it’s the spirit that will always be the final judge of whether a course of action is suitable or not.
Reacting to regulatory changes is less efficient than anticipating them. A focus on the spirit of the laws should ensure that regulatory requirements are met as a side-effect of following processes designed for other purposes.
For more on this, see ‘Focus on the Spirit of Risk Regulation’ and, for the specific case of the MiFID II requirements to consider sustainable-investing preferences, ‘ESG: The Compelling & The Compliant’.
How can behavioural finance improve access to financial advice?
Good advice is out there, but there are barriers to getting it to investors. For example, the proliferation of inconsistent and unhelpfully technical language; behavioural barriers to seeking and understanding advice; and the pros and cons of simplified advice options.
The focus of attempts to do something about this tends to mistakenly focus on products – making them ‘simpler’, or plastering them with more informative labels.
The shortfall lies less in the availability of suitable (or even helpfully labelled) products and more in services that make it clearer and easier for investors to identify the simple set of products most suitable for their (holistic) needs. Services that help them avoid unnecessary complications, and – more importantly – help them acquire the understanding and emotional comfort to invest in and stick with those product solutions already out there.
The problem is much more one of behavioural engagement and emotional comfort than product availability – indeed there are strong arguments that broader product ranges are part of the problem, rather than the solution.
To suggest that the problem is a lack of products is to suggest that everyone with a garage full on unused gym equipment isn’t fitter because they are lacking the latest gadget, rather than because they’ve not learnt to get comfortable using the ones they already have.
For investment decisions to be effective we should always prioritise principles over products, and portfolios over investments in isolation. Product labelling, on the contrary, risks encouraging consideration and comparison of investments in isolation, potentially at the expense of the more important question of holistic portfolio suitability.
Where product labelling might be most useful is where it focusses investors on the role of the investment product in the broader portfolio context. For example, labels that help investors to consider their exposure to particular risks or concentrations (e.g. to single stocks, geographies, sectors, currencies, etc.) when added to other investments in their portfolio against reasonable concentration limits for that investor at the portfolio level.
More important than investment labelling is a clear mapping, with coherent methodology, from the investor to their overall investible assets, focused on long-term needs. This lack of a reliable foundation often leads to considerable inconsistencies between the asset allocation or portfolio risk given to investors with the same identified suitable risk level.
How can Oxford Risk's behavioural suitability tools help you?
The classical approach to investing – treating investors like robots or zombies, by assuming that investing well is as simple as picking an objectively ‘best’ investment and then waiting coolly and calmly until it’s time to cash it in – doesn’t work in real life.
In real life, personal finance is, to its core, inescapably behavioural, which means your suitability processes must be too.
Our tools have been designed to meet the challenges described above. They aim at a deep understanding of individuals rather than a cursory ticking of boxes. Find out more about our Risk Suitability principles in our blog here. We recognise that investing is emotional, and work with this, rather than ignoring it. Our tests are tested to the highest standards. We support decisions throughout the investment journey, rather than relying on a battery of upfront assessments. And we see suitability as an integrated, interdependent system, not a collection of independent components.