A guide to understanding financial behaviour

2

The incomeIQ test – understanding financial behaviour

Take the test – can you recognise any of your clients in these nine behavioural biases?

The incomeIQ test has been developed using cognitive and behavioural psychology theories within a financial setting. It allows investors to discover which behavioural biases affect their financial decision-making and attitudes to risk.

Encourage your clients to take the test at www.schroders.co.uk/incomeIQ and analyse the results together.

Anxiety influences an investor’s emotional engagement with the short term, and the extent to which they allow reactions to the ups and downs of the market to undermine their long-term financial objectives.

Recognising this bias Find market fluctuations stressful and concerning

Affected by temporary market movements

Tend to over-respond to unforeseen events

TipsStick to the plan: Encourage clients to keep records of why they made key financial decisions. This can help them stick to the plan and avoid panic-selling, which could lock in short-term losses in asset-value resulting in an absolute loss in capital.

Don’t look: If clients are overly-anxious limit access to short-term information about their investment returns. This can help them avoid the (potentially frightening) short-term outlook, and help them take the long view on their investments.

Take advice: Remind clients that you can be an emotional ‘shock absorber’, demonstrating the need for an approach based on facts rather than emotions.

Anxiety

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

3

An investor with a loss aversion bias tends to feel losses to a greater extent than equivalent gains. It can make following the ups and downs of risky investments feel like an emotional rollercoaster.

Recognising this bias Tend to hold losing stock too long for fear of ‘cashing-in’ a loss

Tend to sell winning stocks too soon for fear of losing their gain

Tend to avoid volatile investments with high long-term yield for fear of short-term losses

Show a limited ability to take a rational view of financial outcomes

TipsLook beyond performance: If clients are considering selling a product, remind them it’s not enough to know whether its performance is strong or poor. Decisions need to be based on analysis of the true merits or pitfalls of the product, and on what alternative investment options can offer.

Resist the urge to avoid losses at all costs: Fear of ‘cashing in’ a loss might make clients hold onto losing stocks for longer than is wise. Encourage them to take a more rational, focused view.

Suggest a ‘cooling-off rule’: Explain the benefits of a cooling-off period between taking a big investment decision and executing it can provide essential breathing space for reflection.

Loss aversion

Projection biasProjection bias is the tendency to falsely project current feelings onto a future event. When people try to foresee their future emotional state, they often make mistakes, forgetting they will probably feel differently when the future becomes the present.

Recognising this bias Can’t decide how much income they’ll need in future based on current needs (forgetting future health needs and financial commitment to others)

Struggle to identify how their future situation may differ from the present

Assume markets will continue to move in the same direction, either up or down

Unable to visualise what their future desires and needs may be

Tips

Consider different scenarios: Encourage clients to envisage several alternative futures, and how these could influence their investment success. How will investment income change for each scenario? This exercise can help clients be more objective when weighing up priorities.

Be conservative: Base investments and contributions today on a worst case scenario to help clients see their future income needs accurately.

Keep emotion out of it: It’s never a good idea to go shopping when hungry. By the same token, it doesn’t pay to make important investment choices when in an emotionally heightened state.

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

Take the incomeIQ test at www.schroders.co.uk/incomeIQ

4

Irrational perception of money

Most people don’t have a rational picture of their wealth and income, viewing these in nominal rather than real terms. This Irrational perception of money bias is dangerous because it stops people from properly thinking through the effect of inflation and compound interest.

Recognising this bias Don’t fully understand the difference between nominal and real income and wealth

Might not fully appreciate the power of compound interest and the effect of inflation on real returns

Might keep too much as cash for long periods of time

TipsSee the real value: Help clients see the ‘true’ value of savings (not just what’s in the bank today).

Use the (rough) rule of 72: If you divide 72 by the annual inflation rate (e.g. 2%), then 72/2 = 36 years for the money to halve in real terms.

Making the most of compound interest: Demonstrate the impact of compounding interest. Show them how a 3% inflation rate compounded over 20 years could erode their savings without them losing a single penny in nominal currency.

Herd influenceAs humans, we’re easily influenced by the ‘herd’ – the collective thoughts and behaviour of those around us. Herd influence is the tendency for investors to irrationally follow the decisions of others, because they wonder what they are missing out on, or what the collective ‘others’ know that they do not.

Recognising this bias Exhibit conformist behaviour in whatever they do

Before choosing an investment they look at what others are doing

Irrationally follow the decisions of others e.g. the dot com bubble

Buy and sell because others do, rather than making independent decisions based on strong convictions and in line with their own needs

Tips Choose for yourself: Remind clients to use only previously determined, objective criterion to make investment decisions, choosing what is most suitable for their investment style not just what others are doing.

Get clued up: Help clients investigate other ideas. Just because everyone is jumping on a certain ‘bandwagon’ doesn’t mean the strategy is correct. Ask them to think ‘what might the others be missing?’ by showing them other ideas.

Resist the urge: Remind clients that when they feel compelled to follow the trend, the majority of investors will be doing the same, inflating the price of the investment.

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

Take the incomeIQ test at www.schroders.co.uk/incomeIQ

5

Present biasAs a general rule, humans care more about the present than the future. Given two similar rewards, humans prefer the one that arrives sooner rather than later. This Present bias explains why so many investors find it so difficult to save sufficiently for the future, even when it’s the right thing to do.

Recognising this bias Prefer actions which bring instant gratification

Tend to choose a lower present reward over a higher future reward

Need to be reminded to overcome immediate desire for reward in favour of delayed gratification

Find it difficult to change their spending habits in order to save sufficiently for the future

TipsControl yourself: Encourage clients to see themselves as two people ‘far-sighted planner’ and ‘short-term spender’. The first wants income over a lifetime; the second wants to spend now. To reach financial goals, the planner must manage the spender through rules that stop short-sighted behaviours.

Default saving: Explore how commitment devices can help, such as workplace pension schemes and other automated ways to make contributions.

Learning from mistakes: Present bias is often repeated. Ask clients to think back to the consequences last time that they did something impulsive as opposed to far-sighted.

Overconfidence bias

Overconfidence bias is the tendency to believe in yourself without giving due consideration to chance, external events or alternative options. It’s dangerous because it can lead to decisions based on opinions rather than fact.

Recognising this bias Consider themselves better than average at selecting the right investments

Tend to ignore possible impact of chance and events outside their control

Tend to take credit for their own achievements and may blame others for their failures

May accept more risk than necessary and may rotate portfolio excessively, instead of sticking to a medium or long-term plan

TipsSeparate chance from skill: In situations of chance, previous outcomes should have little bearing on decisions. Many people often think of their success with investments as down to skill, not chance.

Rely on experts: Remind clients you are an expert who can act on their behalf in areas where they don’t have expertise.

Remind them not to listen to stories: All too often those investments with the most engaging stories are those that have done well in the recent past, leading investors to buy high and chase past performance.

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

Take the incomeIQ test at www.schroders.co.uk/incomeIQ

6

Over optimism bias

Over optimism bias is the tendency to overestimate the likelihood of success and underestimate the risks. Over optimism can result in poor decisions and over exposure to risk.

Recognising this bias Tend to be unrealistic about the future

Tend to make irrational investment decisions, because they don’t perceive future market risk realistically

An inability to think ahead means they often procrastinate instead of taking preventative action when it’s required

TipsDon’t procrastinate: Over-optimism about the future can lead to clients underestimating the need to think ahead and take action today.

Homework: Give clients research on the area or asset class they’re thinking of so they have a good understanding of ‘realistic’ returns.

Use a sounding board: Encourage clients to play devil’s advocate with themselves using you as a sounding board.

Investor literacyThe extent of someone’s knowledge about investments will have a significant impact on their financial outcomes. It is not the case that those with knowledge always do better. But those with lower Investor literacy should consider focusing on simpler, easily understood financial products and place greater importance on advice.

Recognising this bias Tend to be guided more by emotion or ‘gut

instinct’ than the facts

Have a lack of interest in improving their financial knowledge by reading newspaper or specialist online content

Have a confused or distorted portfolio

Don’t have clear investment objectives and get easily confused

Tips Leave your emotions behind: Those with low investor literacy are often guided by their emotions rather than the facts during the investment decision process.

Read, read, read: Offer clients guides, news and links to online content like the incomeIQ website that can help them read around the subject.

Get to grips with pricing: Spend more time explaining the portfolio, where there is risk, avoidable losses and greater potential for ROI.

It’s not about how clever you are: It’s worth reminding clients that everyone has these biases, no matter how clever or financially literate they are. These are mental traps that occur in all aspects of life, but the good news is that once investors are aware of their potential biases they can think more rationally about their investment decisions. You are there to guide them.

Talking points

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

OVER-OPTIMISM BIAS

PROJECTION

ANXIETY BIAS

IRRATIONAL PERCEPTION OF MONEY

HERD INFLUENCE

OVERCONFIDENCE

PRESENT BIAS

INVESTOR LITERACY

LOSS AVERSION

Take the incomeIQ test at www.schroders.co.uk/incomeIQ

Important information: For professional investors or advisors only. This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Schroders has expressed its own views and opinions in this document and these may change. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Exchange rate changes may cause the value of any overseas investments to rise or fall. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA. Registration number 1893220. Authorised and regulated by the Financial Conduct Authority. For your security, communications may be taped or monitored. w47009-EX

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