There is no such thing as the ‘best’ investment. Only the best investment for someone.
On some level, we all know this already.
It would be odd if a carefree graduate with decades of earnings potential ahead of them were recommended the same portfolio as a wary retiree now entirely reliant on their investments for income.
This is why we have ‘risk profiling’. Investments can go down as well as up, different investments have different propensities to go down and up to different extents, and investors can differ wildly in their willingness to trade off the ups against the downs.
But it doesn’t stop with financial risks and returns.
Investments do not exist in a vacuum. They are inescapably intertwined with the financial position, financial personality and wider circumstances of the lives they are serving.
A suitable investment portfolio should be judged not only by its snapshot financial return, but by its ongoing emotional return too. And if emotions get too hard to handle, it can lead to panic selling and consequently any long-term financial return becoming entirely theoretical. Not all costs are as clear as the panic seller’s. The person who holds on, but suffers in silence, pays not in money, but in mental fatigue – costly both in itself, and through the knock-on mechanism that we are all more prone to mistakes (in every area) when we are stressed.
Human investors simply want the best return they can get, relative to the stress, anxiety, and discomfort they are going to have to bear along the journey. And each investor's personality will make them prone to anxiety in specific ways. ‘Behavioural finance’ recognises this, and, by using psychometric assessments to establish each investor's unique financial personality on multiple dimensions, offers prescriptions for what is most likely to provide emotional comfort in the most cost-effective way.
Behavioural finance in practice
It has been shown again and again in behavioural research that our decisions are hugely influenced by the way information is presented to us.
And just as there is no ‘best’ investment, there is no ‘best’ way to report on those investments, no ‘best’ way talk to clients in turbulent markets, and no ‘best’ way to structure an investment decision-making process. To be effective, all these require personalisation. What comforts, fascinates, or imbues one individual with confidence may concern, frustrate, or confuse another. Many an interpretation can emerge in the gap between the message that’s sent and the one that’s received.
Behavioural finance makes finance relevant to real life.
This can be frustrating in one way, but is also great news in another. Because it means there’s rarely a need to change a portfolio itself (via the one, very clunky ‘level of risk’ lever) to radically change the experience of owning it.
The order in which information is presented, the frequency and length of reports, what you choose to emphasise, such as the stories behind particular holdings, or dialling up or down the role of the adviser depending on the investor’s need for involvement to feel in control, and even the tone messages are delivered in, can all meaningfully affect the overall investing experience.
A further important aspect is timing. We know that merely disclosing all potentially relevant information well in advance of when an investor needs to use it doesn’t help them. However, give them precisely relevant information at the time they are making their decision, and you’ve got a fighting chance of helping them towards a better outcome.
The exact prescriptions for these preventative measures will differ for each patient, depending on their behavioural traits and tendencies. Just as some will avoid eating junk food most effectively with a support group while others would rather work away in isolation, some behavioural interventions could target the portfolio itself by tailoring which asset mix will make the investor most comfortable, while others could tailor communication to help investors cope with times of market stress. A rich financial personality profile allows each investor's portfolio and adviser engagement to be deeply personalised and tailored to their needs, providing both financial returns and emotional comfort.
Finding the best solution in practice
Personal finance is behavioural finance. Behavioural finance makes finance relevant to real life. It bridges the gap between the mathematically optimal model village of the textbook and the more practicable, but more psychologically complex world where humans live, in all their haphazard glory.
Ultimately, the true job of a wealth manager is not to give clients a theoretically 'optimal' solution, but to give them the best solution they could realise in practice. Investment plans that better understand investor behaviours help those investors reap the financial and emotional rewards of behaving better with their investments.
Greg Davies
Head of Behavioural Science, Oxford Risk
