Overview

“The emotional tail wags the rational dog.” (Jonathan Haidt)

We human beings are not always as rational or logical as traditional models might suggest. We are often influenced by hard-wired biases and heuristics; put another way: we make mental shortcuts.

Behavioural Economics shines a light on such mental shortcuts and the psychology of decision-making, both individually and as part of a group or crowd.

  • In business, broadly it explores how choices are made and decisions reached, often subconsciously, from the highest executive boards to ordinary consumers.
  • In the investment world, for example, Behavioural Finance seeks to understand how markets or individual securities can be distorted or inefficient due to the influential biases of its participants.
  • Around board tables and within committees, human biases can also lead to sub-optimal decision making, so understanding key aspects of social psychology is an important defence against what is often referred to as “Group Think.

Understanding the principles of Behavioural Economics provides both valuable insights and a strong competitive advantage to those firms and individuals who embrace it, whether in executive decision-making, investment, sales, marketing or in society at large.

Above all, it makes us challenge ourselves.

What’s it all about?

As noted, traditional economic models assume that people are always rational decision makers who fully analyse data and act logically before they reach conscious decisions.

Behavioural economics is important because it disputes this – and therefore, in my opinion, relates to real people in the real world.

Nowhere is this more evident than in people’s attitude towards wealth, savings and investment. One foundation of Behavioural Economics is prospect theory. Multiple experiments and academic research, coupled – importantly – with real life examples show that investors dislike losses with around double the intensity compared to how much they like gains of the same magnitude. Traditional economic theory would suggest this should not happen.

It’s always interesting, therefore, to see how investors approach unrealised book losses on a stock they have previously purchased, for example. Do they still believe in a particular stock that has disappointed? Will they buy more, and risk succumbing to the sunk cost fallacy? Or do they particularly dislike crystallising losses (‘loss aversion’) and start to hope for, as opposed to honestly anticipate, price improvement? And if they were setting up a new portfolio, would they buy the same stock – if not, why not? There are a lot of potential biases and heuristics possible in these circumstances.

The importance of psychology

Human beings have an instinctive, hard-wired reactive way of thinking, as well as a more recently evolved rational, analytical side – what Nobel Prize winner, Daniel Kahneman, calls System 1 and System 2. We all like to think that we are constantly using System 2.  But the hard-wired, emotive and unconscious System 1 can never be switched off and we accordingly rely on it far more than we believe. This can sometimes lead investors and savers to make decisions that are irrational at worst and sub-optimal at best.

Having worked in the investment industry for 27 years at three great asset management firms – Schroders, PIMCO and Goldman Sachs – and in my time witnessed in the markets a variety of financial bubbles and credit crunches, I am convinced that insights from psychology are equally important as economics, indeed probably more important, in understanding how financial market participants act, both individually and in aggregate. Partly as a result of the global credit crisis, and partly because of a growing interest in the psychology of investments, a lot of private investors, as well as institutional pension funds and their consultants, are increasingly interested in the fresh perspective it offers.

Biases

Psychologists estimate that the human brain is potentially subject to over 150 different biases, and other examples include base rate neglect (ignoring the statistical facts and figures, often in favour of an emotionally appealing or attractive story – a real life example is the popularity of some ‘Pseudosciences’ such as astrology or homeopathy, despite minimal supporting evidence); or anchoring whereby we might consciously or subconsciously latch on to a number as a reference point.

In one experiment, Daniel Kahneman, asked his subjects what percentage of African nations were members of the United Nations. Those who were asked whether it was more or less than 10% guessed on average the answer 25%; whilst the answers of those asked if it was more or less than 65% averaged 45%.

Another psychological insight relating to money and savings is confirmatory bias – a common feature in our industry.  We often come to an investment conclusion quite quickly. But then we tend to find reasons to back it up and we often filter out things that do not quite fit our story or our argument.

There are perfectly good evolutionary reasons to be confident and even optimistic. Without optimism, a form of “mental time travel,” as Tali Sharot notes, “our ancestors might never have ventured far from their tribes and we might all be cave dwellers still, huddled together and dreaming of light and heat.” But the optimism bias can lead to mistakes, especially if associated with overconfidence. You could imagine a situation in which an optimistic investor has lots of good reasons to own a stock, having done the research. Now what happens if that person is faced with contradictory evidence or opinion? Often people will reject something that doesn’t agree with their view rather than genuinely re-evaluate the situation.

I have always therefore liked the John Maynard Keynes comment: “When the facts change, I change my mind.  What do you do, Sir?”  We need to question our assumptions.

From biases to bubbles

As a historian, I am particularly interested in booms, bubbles, and busts in market cycles. These are often viewed simply in terms of fear and greed, but in reality they reflect many underlying behavioural biases such as the bandwagon effect, that were just as prevalent in the ‘Tulipmania’ bubble in seventeenth century Holland as they were during the 1990s ‘Dot-Com’ boom. As Mark Twain is alleged to have said: “History does not repeat itself, but it does rhyme.”

For me, behavioural economics draws on all these types of disciplines to a greater or lesser degree – investment, history, psychology, the social sciences and even magic, and I readily use examples from each in my talks.

So what?

As I noted in my recent TEDx talk entitled The Mind, Markets and Magic, the underlying key reason to promote Behavioural Economics in the business world is because I am certain that this topic is going to get more important in everyone’s lives, providing individuals and firms with a competitive advantage. Above all, it emphasises the importance of challenging our in-built biases, in order to optimise our chances of reaching better conclusions.

Interestingly, in anything performance-based, whether in sport or investment, there are elements of luck and skill. One of the things that behavioural economics allows you as an investor to do, I believe, is to dial up your skill.  In other words, to cut out the mistakes that you might otherwise make – and at the same time add to your insights.

Spreading the word

This is why I am so excited about promoting behavioural economics through public speaking and consultancy, as well as working with specialist investor coaching firm Salomon Partners. It is hard to think of any other performance-related activity – sports, classical music, chess, etc. – where coaches and deliberate practice are not mainstream.  Why has the investment industry been so different? The good news is that things are changing and we can learn plenty of psychological lessons, for example, from competitive sport and other performance-oriented areas.

Behavioural economics is certainly gaining ground, not just in the financial industry (regulatory bodies such as the FCA are very keen), but also in media and advertising, as well as in society at large. The behavioural insights team in the Cabinet Office, colloquially called the ‘Nudge Unit’, have found plenty of ways to encourage people to do the right thing for everyone’s benefit, through understanding better how people make decisions. It has looked at everything from school meals to tax collection to health, to savings – and the results are very encouraging. These ideas are gaining ground everywhere.

For example, in Germany, one has to ‘opt in’ to become an organ donor and the consent rate is around 12%. In Austria, where you have to tick a box to ‘opt out’, their consent rate is over 95%. Why the difference? Because of the status quo bias. A similar strategy from ‘opt in’ to ‘opt out’ resulted in the UK’s adoption of auto-enrolment in DC schemes, with beneficial consequences.

In conclusion

Behavioural economics is relevant to everyone; it is fascinating and often fun, and it is backed up by psychology and academic research. Above all, do not underestimate how much it could improve your business and investment decision-making.