The Psychology of Money

I have yet to meet someone who can rotate their right foot in a clockwise direction and simultaneously draw a large ‘6’ in the air with their right index finger. (I know you are trying it right now and I also guess that you are laughing that your foot inadvertently turns anti-clockwise.)

The human brain is extraordinary, and it does not always work the way we think it should.

Traditional economic models, for example, 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 the psychology of money is prospect theory. Multiple experiments and academic research, coupled – importantly – with real-life examples, show that investors dislike losses about twice as much as 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 purchased. 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 (including short cuts) possible in these circumstances.

The Hard Wiring

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 the analytical System 2. But the hard-wired, emotive and unconscious System 1 can never be switched off, and will sometimes lead investors and savers to make decisions that are irrational at worst, sub-optimal at best. In the words of social psychologist Jonathan Haidt, “the emotional tail wags the rational dog”.

Having worked in the investment industry for 27 years at three major 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 and economics are equally important. Indeed, psychology is 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, many private investors – as well as institutional pension funds and their consultants – are increasingly interested in the fresh perspective psychology offers.

Psychologists estimate that the human brain is potentially subject to more than 150 different biases. 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%; while the answers of those who were asked if it was more or less than 65% averaged 45%.

Another psychological insight relating to money and savings is ‘confirmation 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 argument.

Changing your mind

There are perfectly good evolutionary reasons to be confident and even optimistic. Without optimism, a form of “mental time travel,” as neuroscientist 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 ‘confirmation bias’ can lead to mistakes. 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.

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 17th 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.”

My favourite pastime outside work is performing magic. As a magician, what fascinates me is the way the human mind works. And, dare I say, how it sometimes does not work very well. Magic’s overlap with psychology is extraordinary. When performing magic, my intention is to use some of those hard-wired human reactions and human biases using misdirection, or fooling their minds, or hopefully making them go ‘Wow!’

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.

Gaining the advantage

As I noted in my recent TEDx talk entitled ‘The Mind, Markets and Magic’, the underlying reason to promote behavioural economics in the business world is that I am certain this topic is going to become 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.

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 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.

This is why I am so excited about promoting behavioural economics through word of mouth, as well as coaching investors with Salomon Partners. It is hard to think of any other performance-related activity 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 Financial Conduct Authority (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’, has 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 and tax collection to health and 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 about 12%. In Austria, where you have to tick a box to opt out, the consent rate is more than 95%. This difference comes from the so-called ‘status quo bias’. A similar strategy resulted in the UK’s adoption of auto-enrolment in defined contribution schemes, with beneficial consequences.

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.

Published on 17/2/2015