Emotive reasons behind financial decision-making
Investors have many different types of behavioural biases that affect their investment behaviour. To a detached onlooker most of these may seem irrational. The relationship between an intermediary and a client should be one where the intermediary mitigates and manages the biases of the client. To be able to do this effectively, the intermediary must know his client well in order to identify his biases. It is also important that the intermediary is mindful of his own biases. This relationship of mutual understanding should, in the end, be to the greatest benefit of both parties, says Albert Botha (pictured right) of Glacier Research.
A new field in economic theory called behavioural finance focuses on the emotive reasons for financial decisions. People can be emotional and irrational, and these emotions can affect the financial decision-making process. Further, clients often have unrealistic return expectations while also being highly averse to risk, or they could even believe that investing offshore is a fool’s gamble.
It is becoming increasingly important for an intermediary to manage the client’s expectations. He needs to recognise the client’s behavioral biases, change them if possible or at least minimise their impact. Failure to do so could cause the client to lay the blame on the intermediary’s shoulders.
Optimism and overconfidence are two examples of common behavioural biases in investors. Overconfidence leads investors to believe that they have a unique insight into, or possess the ability to outperform the market. This may be due to them having achieved a modicum of success in the past and believing that they can continue to do so in the future. Overly optimistic investors may erroneously base their return expectation on the last couple of good years and project these performances into perpetuity.
These are difficult biases to correct. An intermediary needs to be positive about the possibilities of investing at all, while still delivering a warning of the dangers and possible losses. The problem is that there is no one way to do this. Behavioural finance stresses the uniqueness of each investor. This implies there is no formulaic approach to managing clients. However, the danger is that if it is not approached in the correct way clients may be risk-profiled incorrectly or they may look for an intermediary who will not try to dissuade them.
Other biases include investors who are overly cautious or have an aversion to a particular type of investment. This is especially apparent when looking at many investors’ current dislike of offshore investments. Having been burnt in the recent past by the volatility of the rand, many investors seem to have the impression that offshore investments are taboo. The same holds true for investors with an irrational fear of equities. However, both these asset classes are important in an investment portfolio and it would be unwise to exclude them. It is also important to remember that even though a client’s fear of these investments may be misplaced, these fears are still an important factor to consider in the process and must be managed.
The idiosyncrasies of each investor are central to behavioural finance. Therefore it is impossible to impose a formula that is applicable to all situations. The relationship between client and intermediary is paramount, because knowing your clients will enable you to steer them past their own blind spots and help them reach their investment goals.
