The concept of behavioural finance has become popular in the debate about how best to shape public policy and regulation in UK long-term savings, with auto-enrolment in pensions being the most conspicuous example.
But while paying lip service to behavioural finance has become fairly common, real in-depth analyses of how to use it as a tool to improve decision-making, especially for long-term financial decisions, are rare.
So what is behavioural finance? Here are the basics:
In an old Scottish phrase, someone might be said to have “a face like someone who had lost a pound and found a penny.” This illustrates the fact that generally we are loss averse. Loss aversion means that losing a thing you value makes you feel sadness that is far greater than the happiness you experience when you gain something of equal value. Does this ring any bells with you?
Then you have diminishing sensitivity. Why is it that the first mouthful of a delicious meal tastes much better than the fifth, and the fifth bite tastes better than the tenth? This is because our sensitivity gradually reduces.
Further, imagine someone earning £20 an hour having their wages cut by £5 an hour. Of course they would feel the loss a lot more than someone on £40 an hour would feel the same reduction.
This bears out the theory of the reference point. All of us – including your clients – think about our finances using mental assessments of what we expect or feel entitled to receive.
Outcomes which are better than the reference point are perceived as gains, and ones that are worse are perceived as losses.
More and more consumers with these perceived losses feel resentful and increasingly seek redress, which is of growing interest to the FCA, especially with the advent of pensions freedoms, the ‘insistent client’ and transfers from DB schemes.
These are the main tenets of behavioural economics. Understanding these ideas can help everyone – you, your staff and more importantly, your clients – make better decisions.
But how many of you actually work for firms which have a policy to develop an understanding and applications around the psychological processes of client decision-making?
Also, how many of you factor this into your direct and indirect dealings with clients, such as those involving advice processes and financial reports, and preparing recommendations and reviews?
Some of you may be asking why this should matter to you. Well, behavioural finance is highly relevant for financial services for a number of reasons:
• The FCA is very interested in behavioural finance, as it can help the regulator understand the mistakes consumers make, how firms respond to these mistakes, how this affects competition, and what interventions the FCA might consider making in the future.
• It can help advisers and paraplanners deliver better consumer outcomes.
• Firms can use it to demonstrate a proactive commitment to delivering those better consumer outcomes.
• Advisers who are aware of behavioural finance and its impact can better understand their own biases and adopt change strategies.