Imagine the scenario. You’re an avid football fan and you’ve managed to get a ticket to watch the World Cup Final. You’ve paid £100 for the ticket, but a friend offers you £200 for it (assuming that you’re legally entitled to sell it on). You politely decline. A ticket tout offers you £500 for it. You still say no. When you’re asked just how much compensation you’d need to part with that ticket, you struggle to come up with a number less than a huge, life-changing amount. And even then, if you took the money, you feel you might still have regrets.
Welcome to our series on behavioural finance. Behavioural finance (part of the broader field of behavioural economics), is the field of study that seeks to explain situations like the above. The situations where real people make real financial decisions that might not be easily explained or predicted by traditional economic theories.
For the next ten weeks, we’ll be looking at a different aspect of behavioural economics every week as a way of examining just how much our decisions can be influenced by factors other than the cold, hard calculations we might think we’re making as informed investors.
We are all prone to biases and emotional thinking. It’s part of being human. These are not ‘problems’ we can ‘solve’ as such – behavioural economics rests on the recognition that we are all only human after all – but having an awareness of them can certainly help us in our approach to investing (and life in general).
In order to give some of the key concepts substance, and in an attempt to bring the theory to life, we’ve considered areas where the biases manifest themselves in real-life decision making. I recently wrote about myself and my family moving to Dorset and the various questions we contemplated beforehand. Looking back, our decision-making process was affected by my loss-aversion, anchoring, status-quo bias and under-confidence – all of which we’ll cover in this series. It’s no wonder it took us so long to move house!
The Sphere of Behavioural Economics
Until a number of economists and social scientists mounted a challenge to traditional and established thinking in the mid-1970s, established economic theories didn’t offer a way to take human behaviour into account. Broadly speaking, economic theories were based on the assumption that in any given situation humans make rational, economically-sophisticated choices with all the relevant information to hand.
As a simple example, in the world of the traditional economic theorist, the holder of the World Cup ticket in the above example would accept one of the offers to buy it above face value, because it makes clear economic sense to do so. By their reasoning, it would be a sound and successful economic exchange and a rational decision that would lead to an increase in the seller’s total wealth.
A handful of revolutionary economists and psychologists argued that it’s not quite as straightforward as this. They believed that traditional theories could only tell part of the story and that if we wanted to understand more accurately how we make financial decisions we would need an approach that acknowledges the very human-ness of humans.
Our World Cup ticket dilemma is just one example of the vast area that behavioural economics covers. It exists at the intersection between economics and psychology and looks at the behaviours, biases and beliefs that we all carry around with us and employ when making financial choices. It acknowledges the life experiences we all bring to bear on every decision we make, often in situations where we don’t have all the information to hand but need to make a choice anyway. Ultimately, it asks how we can hope to accurately discuss the ways that people make financial decisions without at least an acknowledgement of all the human factors that can affect each one.
The Revolutionaries and the Birth of a New Discipline
In the early days of behavioural finance, one of the economists leading the charge in this growing movement was Richard Thaler, who was just this week awarded the Nobel Prize for Economics! He used to keep a list of anomalies that market-based economic theories couldn’t explain on the blackboard in his office in the University of Rochester. Below are a couple of examples of the sort of entries that made the list:
- The basketball fans who decide not to use free tickets to a basketball game as the weather is too bad to drive there, but who agree that had they bought the expensive tickets they would have attempted the journey in a blizzard.
- The woman who would drive to the next town to buy a radio that was being sold for £35 instead of £45 in her own town, but who wouldn’t make the same journey for a TV reduced from £495 to £485.
Thaler became increasingly interested in these types of anomalies and his list kept growing, but he didn’t know what to do with it until he crossed paths with two psychologists called Daniel Kahneman and Amos Tversky. Kahneman and Tversky were establishing a way of understanding common human decision-making errors as a result of the biases they held. Between them, these three academics were the founding fathers of behavioural economics and behavioural finance.
What Does It Mean for the Investor?
Our series will show how an understanding of behavioural finance can help investors, as well as advisers, as they plan for the client’s financial future. In the following posts we’ll be exploring a number of concepts in this area of study, including: projection and hindsight bias; overconfidence and under-confidence; self-serving bias; herding behaviour; the Gambler’s fallacy; loss aversion; and, mental accounting.
At the end of each post we’ll set out some questions you can ask yourself as a way to keep alert to these biases and tendencies that are present in all of us, and to help keep them in check when making investing decisions.
We’ll also be including key insight and guidance from psychotherapist Professor Brett Kahr. Professor Kahr has worked in the mental health profession for over forty years. He is Senior Fellow at Tavistock Relationships at the Tavistock Institute of Medical Psychology, in London, and, also, Senior Clinical Research Fellow in Psychotherapy and Mental Health at the Centre for Child Mental Health in London. Professor Kahr is a Consultant to The Bowlby Centre and a Consultant Psychotherapist at The Balint Consultancy. Author or editor of ten books and series editor of more than fifty other books, he is also a Trustee of the Freud Museum London.
Update: Parts 2 to 10 of our Behavioural Finance series are now live!
- Part 2: Prospect Theory and Loss Aversion
- Part 3: Availability and Representativeness
- Part 4: The Law of Small Numbers, Gambler's Fallacy and the Hot-Hand Effect
- Part 5: Anchoring, Conservatism and Herding
- Part 6: Overconfidence and Under-Confidence
- Part 7: Self-Serving Bias
- Part 8: Projection Bias & Magical Beliefs
- Part 9: Mental Accounting
- Part 10: Next Steps – How we apply the Insights of Behavioural Finance