For many decades neo-classical economists have influenced public policy, which has been based primarily on how rational people should behave.
In this lovely, straightforward world (with lovely straightforward graphs), individual human beings become units, operating methodically and predictably with complete clarity of thought and purpose.
Behavioural economists such as Nobel Prize winner Richard Thaler are less interested in how people should behave, and much more focused on how people actually do behave.
Individuals are not rational – we are emotional beings, reacting to events and assimilating information based on mental short cuts and assumptions that can be hard-wired into our genetic code, or result from our upbringing and environment.
Mr Thaler was awarded his prize for creating a "more realistic analysis of how people think and behave when making economic decisions".
Helping clients have a much deeper understanding of their own personality and attitude to risk can be a great help in overcoming rash or ill-thought-out decision-making when it comes to investments, and as such is now a crucial element of the adviser-client relationship.
Advisers have always taken a ‘coaching’ role with clients, which is crucial in building trust and delivering true peace of mind.
That role has never been more vital than today. Unpredictable markets and a backdrop of uncertainty, as we have experienced in recent months with the coronavirus and Brexit transition, are the perfect conditions to lead investors into reactive, emotive decisions.
Understanding the basis for unconscious behaviours and the emotional triggers of people has rarely been more relevant than it is now.
Deciphering why your clients might be behaving in certain ways can help you coach them away from those mistakes, as well as helping maintain your own sanity when faced with apparently irrational clients hell-bent on doing the ‘wrong’ thing.
And this needs to be an ongoing activity. Your clients may fall into the trap of subconsciously telling you what they think you want to hear: that they understand about market volatility and the importance of a long-term financial plan.
But how they react when a hypothetical scenario becomes reality can not be predicted, which makes communication essential during challenging times.
Examining some well-known investment behavioural biases
Behavioural biases are irrational beliefs or behaviours that can unconsciously influence our decision-making process.
There are two subtypes. Emotional biases typically occur spontaneously, based on the personal feelings of an individual at the time a decision is made. They involve us acting based on our feelings rather than concrete facts, or letting our emotions affect our judgment.
Cognitive biases are errors in our thinking that arise while processing or interpreting the information that is available to us.
These biases can easily affect our decision-making, particularly when it comes to financial matters. And this is not just at an individual level.
The markets themselves are still largely driven by human beings with their own behavioural biases, which is why during times of crisis the market itself can appear to be acting ‘irrationally’.