Confessions of a dangerous mind

Advisers make decisions every day based on the information clients provide to them. But what happens when clients are unaware that their own mind-tricks could be producing false information, skewing their true risk profile, and making them overly-conservative or over-confident? The effect on their financial goals and the adviser's strategy for that client would be obliterated and redundant.

That is where a fringe concept of portfolio management comes in: behavioural finance. It attempts to analyse and identify how emotions and cognitive errors influence the decision-making process related to the saving, investing and spending of money. Not just the preserve of Oxbridge and MIT boffins, elements of behavioural finance have piqued the interest of The Actuarial Profession, the Securities & Investment Institute and even financial exclusion charity, the Resolution Foundation regarding proposals for generic financial advice. Some hedge funds even apply behavioural finance theories to unearth alpha, risk-adjusted return, according to the London School of Economics.

With treating customers fairly at the forefront of IFA's minds, not to mention the industry's transition towards greater professionalism, the psychology driving an investor's decisions suddenly seem acutely important.

Bruce Weber, professor of information management at the London Business School, which covers elements of investment psychology, said: "People's relationship with their money is complex and emotional. The academic field of finance details how to select investments and make rational financial choices. But closer examination shows that individuals and even market professionals deviate from these models. People's rationality and willpower are limited. Psychological biases often mean that money is not managed according to theory."

While we are all familiar with the concept of herd mentality, in which the irrationality of a group of investors follows the same course of action, but there is a range of other theories which, if understood by advisers, could help them better gauge the true financial approach of their clients. Behavioural finance advocates believe that in the absence of better information, investors assume current prices are about right so in a bull market, each new high is 'anchored' by its closeness to the last record and more distant history appears increasingly irrelevant. Anchoring could account for previous and present price bubbles, from technology stocks in the late 1990s to the housing market today.

Then there is regret theory, in which herd behaviour is legitimised because the pain, or regret, of going against conventional wisdom and getting it wrong outweighs the advantages of possibly getting it financially right. Money managers and financial advisers are not insulated from this risk either.

Some academics believe that active fund management is about providing a scapegoat for under-performance. In Fortune and Folly: The Wealth and Power of Institutional Investing, the authors concluded that pension scheme trustees, in the US, allowed blame deflection to play an active role in their investment strategy and hired investment managers for little other reason.