We are not rational thinkers, but emotional creatures when it comes to making financial decisions. This idea has been gaining currency ever since the acclaimed psychologist Daniel Kahneman won the Nobel prize for economics with Amos Tversky for their work on behavioural economics.
Many experiments have shown that it’s easier for us to part with money if we’re paying by card rather than in cash, for example. Long-term investors and short-term traders are not immune from behavioural biases either.
I don’t think anyone can really take responsibility for anyone else’s emotions and trading platforms are no exception
Luckily, these behavioural biases are well documented. We are, in other words, predictably irrational. We know that people are prone to holding on to losing bets for too long, while selling winners too soon: overconfidence and loss aversion. We are inclined to panic when markets are volatile. Any attempt to make sound financial decisions must, therefore, take our emotions into account.
But how, if at all, are online platforms assessing the emotional and mental state of their clients? And to what extent is it their responsibility from a regulatory and ethical point of view?
How to spot potentially vulnerable investors
On execution-only platforms, it’s purely up to customers to decide what they trade and how often. Charlie Musson of investment platform AJ Bell says: “We can see trading patterns, but we have no way of knowing our customer’s emotional state without calling and speaking to them, which in the vast majority of cases would be unwarranted and unwelcome.”
There is one important exception to this: vulnerable clients, including those who suffer with mental illness, Alzheimer’s or dementia. In the UK, the Financial Conduct Authority defines a vulnerable customer as “someone who, due to their personal circumstances, is especially susceptible to detriment, particularly when a firm is not acting with appropriate levels of care”. The regulator requires platforms to protect the interests of these customers.
“We do have measures in place to try and identify these customers,” says Mr Musson. Staff are trained to spot clients who are confused and forgetful on the phone, among other things. “In some circumstances people can automatically be identified as potentially vulnerable, namely when they are in receipt of death benefits or when junior SIPP or ISA accounts are converted into ‘adult’ accounts,” he says.
How information is presented impacts emotional response
But what about all other customers; should people be responsible for their own emotions? After all, for example, we know that the way a product is designed can have a huge impact on people’s financial decision-making. Therefore, platforms already influence our emotions through how they’re designed.
Research from America and the UK into credit cards has shown, for instance, that people pay off more or less of their debt, depending on how the minimum amount is displayed on credit card statements. Generally speaking, whenever there’s a numerical scale to choose from, people are influenced by so-called “anchors”. This means, the way fees or performance figures are displayed influences how we act.
So, when it comes to behavioural design, platforms can ensure they don’t present information “for the sake of it”, argues Greg Davies, head of behavioural science at consultancy Oxford Risk.
Let’s imagine two investors with the same portfolio, who log into their account online. The first one sees a table with many columns of short-term performance. Inevitably, this investor will see something that’s flashing red and emotional angst will set in.
Now, imagine a second investor, who logs in and sees an overall performance figure of their portfolio on a rolling annualised basis over the last three years. “That’s presenting information; that’s much more aligned to people’s objectives,” says Dr Davies. The second investor can then look into the details of the portfolio, but they get a snapshot of the bigger picture at first. “Nothing is more detrimental to good financial decision-making than being constantly in touch with the granular detail of your portfolio,” he says.
Largely left to customers to control their impulses
Clare Flynn Levy, founder and chief executive of Essentia Analytics, says: “I don’t think anyone can really take responsibility for anyone else’s emotions and trading platforms are no exception.”
Although she warns that it is easy for online trading to turn into gambling. “The few retail trading platforms I’ve spoken with know this and, although they are making money, it worries them. Clients with undisciplined investment behaviour lose all their money too fast, which means they stop being clients, and that’s bad for business,” she says.
It may, therefore, be in the interest of platforms to help their clients avoid emotionally-led trading.
Dr Davies wonders whether platforms should encourage their clients into long-term investing. After all, research has shown that people who trade frequently tend to have worse long-term returns on average. That’s mostly because of transaction costs. Platforms have to weigh up short-term versus long-term interest. In the short term, many platforms derive earnings through transaction fees. But in the long run, they would benefit if their clients are better off. “There are always trade-offs to be made and not everybody will put the customer first,” he concedes.
When it comes to emotional reactions, it’s still largely up to customers to counteract their own impulses. As ethical standards in the industry continue to evolve, so do our insights into behavioural economics. Instead of monitoring clients’ emotions, which would raise privacy issues, platforms could help clients make better decisions by giving them tools, such as setting down their investment principles in advance, that will help them counteract their emotions once volatility strikes.
This article was originally published in the Times’ Raconteur supplement on 9 July 2019: https://www.raconteur.net/finance/emotional-investing