When a client isn’t a rational investor

Classical economic theory is fundamentally based on the rational (hu)man model, where we make decisions that are well-researched and in our best interest.

Theorists Von Neumann and Morgenstern called this utility maximisation, although the utility in question was almost always wealth or financial improvement. Economic models are developed to anticipate movements in markets and the outcomes of policy decisions by governments on the primary basis of the rational model.

But what if we are not rational at all? Behavioural finance and behavioural economics are based on evidence that we do not always act rationally and are subject to persistent biases in our decision-making that leaves us less than utility… maximised? Behavioural finance has been around since 1912 but became much more mainstream after Kahneman and Tversky identified prospect theory as a reason for loss aversion. Since then, biases have been ‘found’ to explain all manner of errors of judgment. In the behavioural world, these errors are uncontrollable and apply even if we know about them.

Ed’s note: This is the first in a three part-series of columns Paul Moran will write exclusively for Professional Planner based on his Ph.D. thesis exploring investor decision-making.

My research suggests that there is a third option. I found that non-professionals (our clients) do, indeed, invest rationally – but for the wrong reasons. Despite Markowitz’s view that we should all invest optimally along risk and return lines, non-professional investors make errors of judgment regarding risk and return, often matching high returns with low risk and vice versa.

Meir Statman has been writing lately about the influence of emotional reasons for making errors in decision-making. He uses the example of someone spending $50 on flowers for their beloved for Valentine’s day. Surely it would be better value to invest the $50 on their behalf as the flowers will be worthless in as little as a week. Ignoring the intrinsic cost of a divorce, we can see that there are myriad emotional reasons that we make decisions that, at face value, might be seen as irrational, but are in fact, rational for non-financial reasons.

Considering assumptions

Rather than focussing on investor biases, we may need to consider the assumptions non-professional investors make in their decisions which are often very different from capital market assumptions. These assumptions rarely see the light of day as they tend to stay at the ‘back of mind’ but facilitating a discussion to explore these thoughts and having the clients articulate them can lead to changes in behaviour.

But how to encourage them to articulate these assumptions? In simple terms, ask them to predict the future returns of investments they are considering. Not in percentage terms, but actual dollars. In the survey I used to collect the data for my thesis, I asked the question, “what would you expect the value of this investment to be in ten years?” ‘This investment’ was either a superannuation fund of their choice, a good quality Australian share portfolio, or a residential investment property, and the starting value reflected their personal circumstances based on household income, current super values and the value of the property they lived in now.

To make it easier to complete, I provided them with ranges (i.e., $800,000 – $860,000) that reflected returns ranging from 0 per cent to 12 per cent per annum.

Interestingly, when put in dollar terms, the participants became very conservative, and average expected returns dropped to well below capital market averages. I found that those who preferred property investing particularly changed their view when asked to consider investing in these terms.

More research is needed to understand the reasons for this better, but I suspect it relates to the inability to ‘do the maths’. Again, rather than assuming this is a bias, I believe that it reflects poor numeracy skills combined with a desire to simplify the investment decision-making process.

We all understand the complexities of investment decision-making, and so it is natural that we might want to simplify this to catchphrases such as “property doubles every seven years” or “shares are too risky”.

Having a deeper, and sometimes uncomfortable, conversation with our clients about their investment beliefs and the assumptions they are making can effectively clear the air and avoid the conflict we have all experienced in encouraging clients to do ‘the right thing’.