Take the Behavioural Finance Professional Refresher to earn 60 mins CPDBehavioural finance, as defined in the module, involves applying the psychology of decision-making to financial market behaviour. It affects firms, clients and advisers. Primarily, behavioural finance theory is about tackling poor investment choices.
Background
Behavioural finance attempts to explain how we make financial decisions, which may not always be rational, as traditional theories would suggest. Modern portfolio theory, for example, assumes that markets are efficient and that investors make logical decisions by assessing information including revenue, debt level, projections and more.
This contrasts with a behavioural finance perspective that “considers heuristics, biases, herd instinct, cognitive and psychological drivers”, and acknowledges financial market participants as “complex” and “driven by both emotions and bounded rationality”.
Biases and heuristics
We all have biases. It is part of the human makeup. Two main biases we can consider are cognitive and emotional. The module gives the ‘herd instinct’ as an example of cognitive bias, which refers to following the crowd by reacting to stimuli the same way others do.
From a modern-day investor’s perspective, following other investors’ habits is viewed as irrational because it may result in a lower-level outcome. An example of herd thinking is the ‘dot-com bubble’ in the late 1990s when internet usage was on the rise. Investors jumped at the soaring share prices of internet companies, only for them to crash in early 2000. These businesses had low valuation metrics, but this was overlooked by investors, and inevitably the companies went bankrupt. An exponential amount of investment capital was lost.
Heuristics are known as ‘mental rules of thumb’ as an approach to problem-solving, but more specifically, the module describes it as “mental shortcuts an individual unconsciously takes in order to reach a decision.”
There are different types of heuristics where a rush to make investment decisions could result in a failure to consider all available information and thus may lead to biased decision-making. Confirmation bias, for example, occurs when “individuals seek information that confirms (rather than contradicts) their existing position; thus, they ignore potentially useful information that refutes their preconceptions.” All have the potential to lead investors into making poor decisions.
The regulator’s perspective
The module points to concerns stated by the Financial Conduct Authority (FCA) on using behavioural insights to “take advantage of consumer biases”. The FCA Occasional Paper No. 26 (2017) shows that advertisements of financial products can affect consumers’ actions in three stages. This includes consumers noticing adverts relating to a product that the consumer is interested in, otherwise known as the ‘see’; misleading information known as the ‘interpret’ stage; and the resulting action, driven by emotion, having gone through both stages is known as the ‘act’.
‘Framing’, which falls under the interpret stage, sees companies creating pricing structures that appear attractive. One way this is done is by presenting charges as percentages rather than a figure because a lower percentage charge looks more appealing than a higher cash amount.
Implications
Outlined in the module are some of the most significant implications that biases or heuristics have for investors and advisers. One specific example looks at the stage when an adviser is selecting investments with their clients. An investor may be inclined to select a popular company because they recognise the name. In this case, advisers should encourage their clients to be more objective in their choices and financial services professionals need to be aware of their clients’ biases as well as their own biases.
How do you check your own biases when communicating with clients? Take our Professional Refresher for some guidance on how to tackle these issues.