Practical behavioural economics for beginners


Practical behavioural economics for beginners

Although we all like to be thought of as rational creatures, experimentally we make relatively few decisions on the basis of logic and cold, hard reasoning. This creates problems and opportunities for ourselves, marketeers and suppliers, as we do not necessarily make the right decisions and we cannot generally articulate how we got there in any case!

Behavioural economics has a lot of different threads, with strands of psychology, neurology, economics, sociology, linguistics and a passing acquaintance with many other branches of study. So it is hard to come up with a unified theory of anything, but the idea of people being given “nudges” to do something seems to be commonplace.

If you want someone to undertake a specific behaviour, telling them outright to do it will often require an incentive, from direct coercion to a cash reward, which could be unethical, uneconomic or both. Implying that the same behaviour will give them widespread social appeal, that their peers are doing it and that they only have a limited time to do it, may often increase compliance at a much lower economic and social cost.

Often these “nudges” are connecting with a previously learned short-cut in thinking or a specific bias that engages with “System 1” thinking. Daniel Kahneman suggested a dual system theoretical framework for thought processes. System 1 consists of intuitive, automatic, experience-led and unconscious thought giving a rapid conclusion and System 2 is more reflective, conscious, deliberate, controlled and analytical.

System 1 thought gives rise to heuristics, cognitive shortcuts enabling a person to discover or learn something for themselves, these allow people to come to a rapid conclusion which they feel happy about. It is impossible to generalise about the quality of the decision without a lot of information, but in general humans are usually content with a “good enough” solution rather than the optimal one, based on the costs and constraints involved. 

As IFAs, we are very interested in the process of decision-making and we are heavily invested in the need for our clients to make the best decisions possible. A lot of this is providing the raw materials for clients to make their own heuristics, based on our knowledge and experience, coupled with trust in our judgement. A key element is an understanding of some learned “rules of thumb” that form part of the financial heuristics for life.

Always hold back some of your income.

Everyone needs to maintain an emergency fund, or they will find themselves having to borrow money at high cost to meet life’s little crises. Conventional thinking is up to 6-12 months of after tax income. Never over-commit your resources, as your wealth and wellbeing will suffer.

Don’t put all of your eggs in one basket.

In investment and saving, diversity is your friend and ally. If one plan goes wrong, another should go right.

If you do not understand an investment, don’t do it.

Investment should be simple, the bulls**t and bluster of others is never to your advantage, so complexity should always be a ‘warning-off’.

If they are desperate to sell today, you need to rethink your decision to buy.

Retail financial advice is considered and bureaucratic, so pressure to do something immediately should be a warning that something is not right.

If there is a big incentive to the adviser, then it will be poor value for the client.

Margins on all financial products are coming down, so any commission over 5% is a red flag for any transaction. The common factors between scams and frauds are high commissions for introducers and urgency to the transaction.

There is no such thing as a free lunch.

In a capitalist society, everyone is after an angle, so there is no such thing as free advice, you will be paying for it in some coin or another. Once you understand the actual cost, you will be fine but you need to make an effort to establish the coin and pay the price.

Familiarity is not safety.

Just because something is familiar does not make it risk free; living in a house does not make you a buy to let expert; just because something has always been done one way does not make another way worse.

Don’t judge a book by its cover/All that glisters is not gold.

Appearances can be deceptive, especially with investments; the only thing that matters is the investments that underpin your investment, so the gloss is irrelevant. Get confirmation direct from the provider that your investment is what you are told and check values with third parties like www.trustnet.com.

Investment-wise, never get yourself backed into a corner

The day you have to sell an investment is the day you will crystallise a real loss. Always manage your liquidity, so you always have hold or sell choices and separate your day-to-day income from your investments.

Beware the time value of money

Inflation is always the elephant in the room; even modest rates of inflation will erode the value of your capital over time. The Treasury target of 2% will halve the value of your cash in around 35 years. £1,000 in 1990 has the buying power of £2030.15 in 2014 as inflation averaged 2.9% per year over 24 years. (Details found here). 

Your future depends on your now

Decisions you make now will impact positively and negatively on your future. Although our language allows us to separate between now and the future, our circumstances are a continuum, with no break. Ultimately, your wealth is what you do not spend!

If you would like to know more about how we can help you plan and realise your financial goals then contact us at info@martin-redmanpartners.co.uk or call us on 01223 792 196.

The information contained is for guidance only and does not constitute financial advice. It is based on our understanding of UK legislation, whether proposed or in force, and market practice at the time of writing. Levels, bases and reliefs from taxation may be subject to change. Accordingly no responsibility can be assumed by Martin-Redman Partners its officers or employees, for any loss in connection with the content hereof and any such action or inaction.