How behavioural finance is helping investment managers minimise risk
A decade ago, hiring a team of behavioural finance academics to help investment managers mitigate risk seemed an ‘esoteric’ gamble. Now, says Dr Peter Brooks, Head of Behavioural Finance at Barclays Wealth and Investment Management, the bank’s pioneering approach is seen as a safe bet throughout the industry.
“When I joined, it was a pioneering move for a bank,” says Peter Brooks, looking out over the cityscape of Canary Wharf, “and in some ways it still is.”
“Barclays recognised there was this thing called behavioural finance out there and people were starting to think that there was a group of esoteric academic guys who might have some good ideas, but it was a bit of a gamble forming the team. In some ways, we got lucky as a team, because the global financial crisis hit, and probably the one thing that came out of that with more credibility than when it went in was behavioural finance – the idea that markets and emotions are intrinsically linked.”
It was 2007, five years after Daniel Kahneman had won the Nobel Prize in Economics for his work in behavioural economics. Nudge and Freakonomics were hitting the bestseller charts as people attempted to work out new ways of deciphering psychology’s relationship with trade, money and financial decision-making. And Barclays hired Dr Greg Davies to head up their brand new behavioural finance department, working on risk and personality-based advice for their investment management team.
Behavioural finance really helps us understand how we act day to day, and what short-cuts we take. Money management can be a tedious thing that leads to short-cuts, but the way our emotions create biases tend to lead to inefficiencies and mistakes.
Head of Behavioural Finance at Barclays Wealth and Investment Management
Brooks, with a PhD in Behavioural and Experimental Economics, soon followed, exchanging an ivory tower for one made of glass. On Davies’ departure, he took over the department. “Banks usually have this approach where they tell you what is best, and what they think is best is some definition of what a rational person would do, with all the information, with all the time in the world and with great knowledge,” he says. “That means you should be managing your money perfectly, never borrowing money you don’t need and investing for the long-term, and staying diversified. But actually none of us are like that.”
Behavioural finance concerns itself with eliminating mistakes: “Our approach is ‘if we know there are mistakes, and we know from our understanding of finance the right way to do it, how do we help people de-bias themselves?’ And that’s where the academics come in – we can show the many different ways in which people make mistakes, and create ways of working with people that can make it more obvious what the right decisions are. People have limited willpower and sometimes limited knowledge. It’s our job to find surer ways of customers and clients getting it right.”
Hearts and minds
A typical working week for Brooks is wide-ranging but client-focused: “I’m probably fortunate because there is no typical work day. Our team gets involved in projects, in client events, in writing materials for our client base. We’re not in the world where there’s a process to get-through. So a typical week might involve a working group meeting with the Money Advice Service, doing some writing, meeting some journalists, and also actually sitting down and doing some process design – working out how we optimise ourselves to make it easier for clients to make decisions. And you have to go out and win hearts and minds and sell the vision.”
“We often get picked up by different areas of the bank,” Brooks continues, “so for example last week I wrote an article about social engineering fraud, and why it works because of people’s psychology. Those cross-bank things are quite common, but investment decision-making is where we focus most of our time.”
A key concept in behavioural economics is ‘framing’. Brooks says: “When you start to understand how the world is presented to you, you start to see it all in a slightly different light. Look at how effective charities have been in using behavioural finance logic in creating donations: small value direct debit is the golden source of funding, because it’s such a small payment there’s less inclination to take the trouble to cancel.
“Behavioural finance really helps us understand how we act day to day, and what short-cuts we take. Money management can be a tedious thing that leads to short-cuts, but the way our emotions create biases tend to lead to inefficiencies and mistakes. We try to understand what these mistakes are.”
Making it real
Now, with so many colleagues carrying an at least partially-read copy of Kahneman’s bestseller Thinking Fast And Slow, there’s a more mainstream acceptance of Brooks’ work. Does that make it easier to get across? “In some ways it has, because there’s more recognition. But in some ways it’s made it harder, because it’s one of these areas where a little knowledge can be dangerous. So people read Nudge and Freakonomics, maybe get a little bit into Kahneman before realising it’s bordering academia, but they think they’ve got an idea that the whole discipline is all about nudges, when actually it’s a lot deeper.
“After you peel back the surface,” Brooks continues, “when people can’t make decisions on their own, you can provide that ‘nudge’ as a safety net. But for those who can make a decision, how do you effectively engage with them? There are elements of timeliness, framing, anchoring and the presentation of information. All the tools of behavioural finance need to be brought to bear on the right circumstances for the right person.”
Describing the contrast between his current environment and that of a university economics department, Brooks concedes it can be challenging – but ultimately highly beneficial – to maintain a more scholarly approach when working alongside more time-pressured colleagues. “You often find that people in a business are set up to make a decision and move on,” says Brooks. “But we sometimes say ‘I don’t know what the right answer is… give me time to understand it.’ Being here delivers the most crucial and exciting area of the entire study: how do you make it real? I don’t want to write reams of academic journal articles to increase credentials. I’d rather go out, test things and enhance people.
“There are millions of Barclays customers who potentially will all save a little bit more because of improvements we’ve made and can invest in a better way. Ultimately they might be able to retire or have a better lifestyle, all because of work we’ve done. And that gives job satisfaction, where we’ve taken what I found to be a fascinating academic area and, rather than studying it as an academic area and being in an ivory tower and having no connection with the world, we’ve brought it all to a real environment.”