Do you always make rational financial decisions?

Suppose that you are in a queue at the local theatre and have paid £40 for a ticket. As you enter the theatre, you find out that you have lost your ticket, which cannot be recovered. Would you pay £40 for another one? According to research conducted by Daniel Kahneman, Professor Emeritus of Psychology and Public Affairs at Princeton University in the US, 46% of people would stump up the extra cash.

Now imagine that you are queueing to buy a similar ticket, again for £40. As you enter the theatre, you find out that you have lost £40 from your wallet. Would you still pay £40 to see the show? According to Kahneman, 88% of people say they would not.

This is a peculiar outcome, as in both scenarios the financial positions of both subjects are effectively the same.

This well-known result – an instance of an effect called ‘framing’ – is but one discovery about human responses that has spawned behavioural economics (and, latterly, behavioural finance), a growing area of interest challenging the assumption of rationality that is central to traditional economic theory. The potency of Kahneman’s discoveries earned him a Nobel Prize in Economics in 2002. In more recent times, behavioural finance has been attracting the attentions of the Financial Conduct Authority (FCA), as well as those at government level (see The Government’s Nudge Unit, on page 14).

“Behavioural economics isn’t really one unified theory,” explains Nigel Sydenham, Chartered FCSI, a tutor at BPP Professional Education and author of the CISI’s Professional Refresher elearning module on behavioural finance. “Rather, it is a collection of results, based mainly on psychology, that impart the lesson that probably many people suspected for a long time – that consumers don’t always act with rationality, especially with respect to risk and return.”
Traditional economic theory is elegant, but leave out many of the details that make real life more complex

That traditional theory is based on ‘homo economicus’, a term that describes people as able to make fully rational decisions about what is in their own best economic, or financial, interests.

“We can say traditional or neoclassical economic models are akin to the models of Newtonian physics,” explains Trevor Neil MCSI, Director at Beta Group, a firm that specialises in offering insights from behavioural economics to banks and financial institutions. “These models are elegant and theoretically useful abstractions, but leave out many of the details that make real life more complex. A cornerstone of neoclassical economics is the assumption that people are generally capable of making economic decisions consistently to maximise their own interests.”

Homo economicus would, for instance, have provided Kahneman with consistent answers to the theatre scenarios. He would also be impervious to other effects observed in behavioural economics, such as over-extrapolation, projection bias, using rules of thumb and a host of other behavioural phenomena observed by academics (see The FCA and behavioural finance, left).

A new way

Given that consumers, if not finance professionals, may be susceptible to the odd cognitive slip-up, the FCA is becoming increasingly aware and concerned that unscrupulous wealth managers may be using the results of Kahneman, and many of his colleagues in academia, to exploit their customers through questionable business models, like those that instil too much confidence in their customers. To this end, its first Occasional Paper has been devoted to the theme Applying Behavioural Economics at the Financial Conduct Authority, and signals the authority’s intent to treat the subject more seriously in its oversight of firms. In the paper’s foreword, Martin Wheatley, CEO of the FCA, states: “Behavioural economics enables regulators to intervene in markets more effectively, and in new ways, to counter such business models and secure better outcomes for consumers.”

To many people, including Sydenham and Neil, this statement is to be read as an opening salvo. Given the failures of its predecessor, the FSA, in focusing primarily on the disclosure of financial information rather than the psychological factors at play when products are sold, the FCA is keen to take a more radical approach.

“Historically, the FSA’s position was to shy away from behavioural issues and to require disclosures broadly in line with the homo economicus model,” says Peter Andrews MCSI, Chief Economist at the FCA.

“One of the things that Martin Wheatley has done is to say ‘this is not realistic’. Smart regulation needs us to be realistic about the demand side.”

Part of that realism lies in recognising that not only do customers make mistakes, but that financial services firms might seek to exploit those failings. The FCA has therefore started to conduct some of its own research into behavioural economics, by identifying the types of exploitative business models that operate in the market and, in its Occasional Paper, has indicated ten areas of initial concern.

“Firms are already aware of how consumers actually behave because they have close contact on a day-to-day basis,” says Andrews. “Some of the most sophisticated business models use randomised control trials to find out what is the best way of setting up a website – from the firm’s perspective – given the ways consumers will react according to different stimuli presented.”

A case in point is the issue of tracker funds, which provide a return based on an index, less charges and certain costs not included in charges, and plus or minus a tracking error. According to the FCA, the level of these charges is not systematically related to the level of costs that lie outside of the charges, and the expected value of the tracking error is around zero.
Given the failures of its predecessor, the FCA is keen to take a more radical approach

Andrews continues: “If consumers were acting rationally, they would always choose the tracker fund with the lowest charges. But actually they don’t. Some choose funds with very large fees – almost as large as active funds. It’s really hard to see what dimension of quality could rationalise choosing an expensive tracker fund over a cheaper alternative.”

Explanations for such irrationality in the face of mathematical logic include misplaced trust in certain brands and website design; if customers want to make quick decisions, they may end up being ‘directed’ towards a more expensive course.

More regulation
How far the FCA will eventually go in regulating the industry is a moot point. At barely more than 100 days old, it is too soon, says Andrews, to say how exactly it will design regulation and then act. More fundamentally, however, there remain some concerns in the industry that the regulator may be instilling a culture of placing too much responsibility on the shoulders of finance professionals in the event of poor investment decisions being made.

“The Occasional Paper throws a great many balls in the air by asking a lot of questions and giving examples of abuse of people by those who exploit the public’s biases,” says Neil. “The FCA’s inevitable conclusion is more regulation. A cynic might say it is the stupidity of people that should be outlawed.”

Neil points to the insurance industry to illustrate his point. “What contributes to the insurance industry’s profitability is people’s overestimation of the likelihood of their house burning down. We will gladly pay large sums annually to insure against it – many times the sum that economic theory would indicate we should, given the remote possibility of this disaster. Yet few would sleep comfortably without cover and people are happy to pay through the nose for it.”

Another question being asked is whether the FCA is in a position to decide what products best suit an investor’s own interests – a concern that applies more broadly to the ‘paternalistic’ approach of the Government’s Behavioural Insights Team, which is known more popularly as the Nudge Unit.

“The FCA has indicated it won’t get into product approval, but it will certainly look at product design,” explains Sydenham. As suggested by Wheatley, the regulator is keen to look more closely at business models, and will ask whether specific businesses are designed to cause an unacceptable level of consumer detriment.

This is a point taken up by Andrews: “We don’t want to supplant people’s preferences with the FCA’s. Rather, we think that the choices people are making in real markets probably don’t accord with their own preferences if they were in possession of all the facts and had a good understanding of the implications of their actions.”

Want to find out more about behavioural finance? The CISI is pleased to offer a one-day training course, a Professional Refresher elearning module and videos of past CPD events on the topic on CISI TV.

The FCA and behavioural finance
In its Occasional Paper, Applying Behavioural Economics at the Financial Conduct Authority, the FCA identifies ten areas where it thinks firms may be in a position to exploit their customers. These include: present bias (people make choices for immediate gratification over long-term gain); loss aversion; overconfidence; and framing.

Another is over-extrapolation, where people make predictions about the future based on only a few observations, thus underestimating uncertainty. For instance, over-extrapolation may lead a customer to assess financial advice positively on the basis of a few successful investments, which in fact may have been the result of pure luck. According to the FCA, firms may exploit this bias by presenting irrelevant information based on small samples, meaning that it may have to regulate over what, and how, information is provided by financial firms.

Other terms of interest
Projection bias – People expect their current attitudes and preferences to continue in the future and underestimate how these may change. As a result, they may not save enough for the future or may end up paying too much for financial products.

Rules of thumb – People boil down complex decisions by using ‘heuristics’ such as choosing the most familiar option, avoiding the most ambiguous and sticking to the status quo. Firms may exploit this by guiding people towards certain products.

The Government’s Nudge Unit
The Government’s Behavioural Insights Team (BIT) – better known as the Nudge Unit – was set up in 2010 with the remit, according to its spokesperson, to apply “insights from academic research in behavioural economics and psychology to public policy and services” and to “find ways of encouraging, supporting and enabling people to make better choices for themselves”.

In less formal terms, this means ‘nudging’ people to make choices that are in their best interests, in areas as diverse as car tax, the justice system and loft insulation.

Critics of nudging, however, argue that this approach opens the door for governments to act in ways that are too paternalistic.

“We don’t think we know best what’s in a person’s interest,” continues the BIT’s spokesperson. “However, we do know that how a choice is structured affects what people do, and that in many instances, relatively simple changes to the way that these choices are structured can help people make important decisions that are in their own self-interest. A good example is the new system for automatically enrolling people in to pension schemes. The Government is, in this instance, making it easier for people to save for their retirement without reducing any previously available choice.”