It’s All in Your Mind: Can Behavioural Finance Help Us Make Better Decisions About Our Money?

People aren’t always rational. Our tendency to behave emotionally or
irrationally sometimes has dire consequences on our personal lives, not to mention our investments.

Behavioural finance, the study of the psychology behind investor
decision-making, identifies biases that lead us astray from our saving and other goals. Can we remove these biases from the investment equation to improve our decisions and increase our bottom line?

Although behavioural finance and economics are the subjects of academic journals and popular books, the theory hasn’t always been widely accepted. Daniel Kahneman and Amos Tversky are two economists/psychologists whose influential work in the 1970s and ’80s helped bring behavioural finance into the mainstream. Their pioneering work was chronicled by financial journalist Michael Lewis (Moneyball, Liar’s Poker) in his 2016 book, The Undoing Project: A Friendship That Changed Our Minds.

 

 

To explore this ever-expanding field and what it means for the average investor, we spoke with two experts. 

Preet Banerjee, a Canadian based in London, U.K., is a consultant to wealth management firms who specializes in commercial applications of behavioural finance. A former investment adviser, with a B.Sc in neuroscience and a newly completed doctorate in business administration, Banerjee is also founder of “MoneyGaps,” an online advice tool for Canadian advisers.

Michael Pompian, founder and chief investment officer of Sunpointe Investments, headquartered in St. Louis, Missouri, has authored five books on the subject, including the recent Behavioral Finance and Your Portfolio: A Navigation Guide for Building Wealth.

Behavioural finance “tries to explain why people don’t do the things that they know that they probably should be doing when it comes to managing their money,” Banerjee says. “It’s very similar to going to the gym or trying to change your diet. People know intuitively what they’re supposed to do; the hard part is doing it.”

The term “bias” in behavioural finance is sometimes misunderstood, notes Banerjee. “Bias, fundamentally, as one of my profs says, is just a fancy word for wrongness.” 

Banerjee highlights “present bias,” identifying it as one of the main obstacles to saving for retirement. “The psychological weight of both pain and pleasure is magnified in our brains in the moment,” he says. “The pain of putting money away is that you don’t have money to spend today. … And the reward, which is the bigger retirement nest egg, is so far in the future that the psychological weight in our brains is so low that we tend to too aggressively discount [its] future value.” 

Humans developed so-called cognitive biases for a reason – as mental shortcuts to help them make quick decisions that were often a matter of life or death, Banerjee explains. “Evolutionary biologists talk about how 99.99 per cent of our evolution or time on Earth has all been about making it to tomorrow morning,” he says. “It’s very short-term-focused.”

For investors, that hardwired outlook can be a liability. “When we’re bombarded by headlines that talk about how the market is down two per cent today, five per cent for the week, or this bank is having a bank run or whatever, it gets our attention,” Banerjee says. This results in “action bias,” the impulse under pressure to do something – like selling your stocks in a panic. “These short-term headlines try to pull you away from your long-term plan, which generally is going to be pretty disciplined, has a rebalancing schedule, an asset allocation mix you’re trying to hit.”

In his research, Pompian catalogued 20 biases that play into investment decisions. The best-known is “loss aversion,” first identified by Kahneman and Tversky, who found that investors feel the pain of losses twice as much as the pleasure of gains. 

“People don’t like to lose money, and they try to get back to even, before selling a losing investment,” Pompian says. “Regardless of whether or not these investments are still a good [one], they irrationally hold onto them.”

Pompian’s contributions to the field include categorizing biases as cognitive or emotional, he says. For example, loss aversion is emotional. Whereas mental accounting – when investors put money into different mental or physical accounts for retirement, vacations, bills and so on –is cognitive, or thinking. “What tends to happen is people accumulate too much cash across all these accounts, and they have an unbalanced overall portfolio,” Pompian says.

Emotional biases are harder to correct than cognitive ones, he warns. “If you have a lot of money and you don’t have a high spending need, you can adapt to these biases.” But if the reverse is true, “you may have to change your behaviour.”

Behavioural finance and economics are gaining currency among investment advisers and planners. “I was a heretic when I wrote my first book
in 2002,” Pompian says. “Nobody thought this stuff was real.” It has since gone mainstream, he argues, citing a new “chief behavioural
officer” service for U.S. investment firms. “You can hire these people to train all your people on behavioural finance.” Banerjee is less sanguine: “The industry is still at a point where it’s more lip service as opposed to, ‘How do we apply this effectively in terms of client behaviour?’” 

Meanwhile, bad actors have used elements of decision science to gamify trading. “Think about some of those investing apps that throw confetti on your monitor when you make a trade or give you a free stock to open up an account,” Banerjee says. “They make the stock market more like a casino than a long-term investment vehicle.”

If you’re shopping for an investment adviser with behavioural finance expertise, Pompian recommends posing a few pointed questions. “How have you learned about behavioural finance? What have you read?” Also: “What resources are you using to coach your clients in behavioural finance?”

To get past mental accounting, Pompian suggests going through your accounts and tallying each investment type. “Then, either working with your adviser or working on your own, figure out what your asset allocation is across all these different accounts,” he says. “If you aggregate all of these investments, is that asset allocation truly where you should be?”

Banerjee shares two pieces of advice. First, automate as much as you can – like saving, which is hard for many people. “Then you remove that decision point.” When Banerjee asks successful retirees what was the single most important thing they did to attain wealth, “very few people talk about their asset allocation and rebalancing schedules,” he relates. “They always say, to a T, ‘It was making my savings automatic.’”

Second, as part of a financial plan, he suggests writing an investment policy statement that can help steer you toward long-term thinking. “Because there are so many things that want to pull you into short-term thinking,” he says. “If you don’t have that, you’ve got nothing to latch onto.” 

A version this article appeared in the Aug/Sept 2023 issue with the headline ‘It’s All In Your Mind’, p. 80.

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