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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.

Mr Weber said: "People are social creatures that respond to signals from others, especially in cases where we have incomplete information. We guess the number of jelly beans in a jar differently when we observe others' guesses than when we act independently. Your guess on what the market will do next, will influence my opinion and expectations."

This perhaps ties into prospect theory which describes how people are much more distressed by prospective losses then they are happy about equivalent gains. This loss aversion manifests itself in higher risk-taking to avoid losses than to realise gains. Accordingly, and perhaps epitomising the British love affair with property – 'endowment effect' is where people set a higher value on something they own than they would be prepared to pay to acquire it. Experts in behavioural finance also find that people are particularly over-confident in areas where they have some knowledge but this confidence is not reflected in successful performance. An example of this is over-confident stock traders who tend to over-trade and end up under-performing the market.

Andrew Cheseldine, senior consultant for Hewitt Associates, told the The Actuarial Profession's pension convention in June: "The credit crunch is the classic example of the effects of overconfidence rather than rational decision-making. It is something we look back on and say we should have seen coming but we kept borrowing. Now the market swings back as an overreaction. The human mind has adapted to take short-cuts in decision-making and in the complicated world of finance, that can provide the wrong answer."

Simon Culhane, chief executive of the SII, echoed these remarks at a conference in China this year. He said: "Firms operating in the global financial services industry need to understand that short term action and selfish behaviour threatens long-term stability and prosperity."

In 2003 The Actuarial Profession published a report investigating consumer access to financial advice and consumer risk attitudes. Authors Alan Goodman, Brian Murray and Ian Woods drew on the Banham enquiry which concluded that "mismatches exist between an adviser's perception of his client's attitude to risk and the client's actual attitude." It said this was caused by "imperfections in the sales process, consumer's inability to articulate their attitude accurately and a number of psychological and contextual factors that distort the answer."

As a result of a co-study between the University of Warwick and the Financial Consumer Support Committee, The Actuarial Profession reached the startling realisation that "education may have limited impact on financial decision-making" and that "people often use simple rules of thumb to evaluate the options." The authors were concerned that the way advisers frame questions in their interaction with clients may influence the outcome, such as a client's willingness to invest and level of risk accepted.

Mr Cheseldine advocates investors and their professional advisers to be aware of their own biases, and if possible filter them out; use frameworks and models that challenge statements and assumptions; consider the unpopular; and focus on evidence.

A report published by the Resolution Foundation last year, Influencing Financial Behaviour and the Role of Generic Financial Advise, said that for generic advice to work, it should be given "in light of the lessons learnt from the field of behavioural economics" to ensure it works "with the grain" of people's real-life tendencies.

It addressed the issue of advisers inadvertently framing questions and unconsciously influencing client information and decisions. It suggested six dos and don'ts:

• Do ask the most salient question first

• Do not ask two questions at once

• Do not ask questions which contain assumptions or those with hidden contingencies

• Do not ask hypothetical questions

• Do not use ambiguous terms which mean different things to different people

• Do use a mixture of positive and negatively-worded questions and open-ended questions to avoid leading questions

Claudia Wood, research and policy manager for the Resolution Foundation and author of the report, also suggested emphasising the losses associated with the status quo rather than longer-term benefits of an action to combat regret theory and prospect theory, and suggest short-term achievements with immediate benefits rather than a long-term goal. For example, the tax benefits of pension saving can be illustrated by how many extra hours a client would need to work to achieve the same financial result.

When considering which investment manager to invest with, the London Business School's Mr Weber said consistency is key, looking for those that avoid excessive risk or conservatism. He added: "Knowing the pitfalls that lead to financial excess helps. Having goals and working to a financial plan is the best way to prevent emotional swings from reducing your financial well-being. Speaking to advisers about investment plans should help."

Anna Lawlor is a former senior features writer for Financial Adviser and is currently deputy features editor for Investment Adviser