BEHAVIOURAL FINANCE

The Psychology of Financial Decision Making

About this report
Written by behavioural finance experts at Barclays Wealth, it
seeks to explain how individual differences in psychology
play a vital role in all aspects of financial decision making.

The report is based on existing academic literature

integrated with the proprietary research of Barclays Wealth’s
Behavioural Analytics team.
Foreword
Barclays Wealth aims to provide clients with the means to manage their wealth successfully. For this reason, we are
committed to investing in research that can help expand and deepen our understanding of how clients differ in their financial
decision making, and indeed all aspects of how they manage, grow, protect and pass on their wealth.

Over the past decades, academics and financial practitioners alike have devoted significant resources to trying to identify
investment strategies that are successful regardless of wider economic and financial market conditions. Only a small
percentage of this vast output has been devoted to an area which we view as being fundamental to the successful long-term
management of wealth – behavioural finance. Behavioural finance uses our knowledge of psychology to improve our
understanding of how individual investors make financial decisions, and how these individual decisions cause markets to
behave in aggregate.

Even though behavioural finance is more popular than it was a decade ago, it is still considered a niche area within the
financial services world. There are few behavioural finance funds or strategies available to individual investors. In the
institutional arena, behavioural finance is slightly more popular, but is still far from being considered a core approach.
This is unexpected, as systematic psychological patterns – such as the herd mentality or the tendency for retail investors to
buy investment funds simply because they have performed well in the past – are evident in financial markets every day, and
have been documented for decades. Perhaps more fundamentally, it has been clear for some time that the majority of
investors exhibit loss aversion – so the pain arising from a loss is felt much more keenly than the pleasure derived from a gain
of equal magnitude. And yet, the majority of traditional investment strategies are based on the assumption that we are all
willing and able to participate in losses to the same extent that we are in gains, with no allowance made for the fact that losses
may have a significantly greater impact – both financially and psychologically – than gains.

In simple terms, we do not think it is possible to separate an investor’s personality and the investment decisions that he or she
may make; for us, they are two sides of the same coin. This paper shows how investment and its outcomes, like all human
activity, is ultimately governed by individual biases (‘the market’ after all, is the just the summation of thousands of
individual investor’s views). Individual psychological biases and traits exert significant influence every time we make – or chose
not to make – an investment decision, and also influence how we view and react to the outcome of those decisions.

Academic research into the psychology of finance has dramatically increased our ability to understand individual financial
behaviour in recent years, but this knowledge has until now been a largely untapped resource in commercial applications.
Barclays Wealth is committed to using this cutting-edge resource in our continued efforts to understand our clients as
individuals when delivering their optimal financial solutions.

Greg Davies
Head of Behavioural Analytics
Barclays Wealth
 The myth of
the average
investor
Modern portfolio theory is
built on the assumption of
‘the economic investor’ –
a rational being who
wants the maximum
return for a given level of
risk (or the minimum level of
risk for a given level of return).
However, the ‘economic investor’ is
also presumed to be a dispassionate
individual who is unaffected by
emotions such as anxiety, regret, hope
and fear. The purpose of this article is to
demonstrate that this rational investor
simply does not exist.

Everyone sees the world from a perspective which is

uniquely theirs, and investing is no different. People have
individual goals, requirements, desires, fears and hopes for their
wealth. We all have different habits, different people we trust for
advice, and different beliefs about the right decision on any occasion.
But we all exhibit very similar psychological biases in our financial
decision making, which can lead to poor portfolio choices and subsequent
investment performance.
Understanding your financial personality is vitally important.
It can help you understand why you make the decisions you
make, how you are likely to react to the uncertainty inherent
in investing, and how you can temper the irrational elements
of investment decisions while still satisfying your individual
preferences. In this article we highlight some of the cognitive
‘traps’ in investing that most people are susceptible to.
Thinking about these in the light of your own financial
personality report will help you avoid them. Indeed,
understanding your own financial personality and common
investing biases will improve the investment experience for
you from day one onwards.
Improving your Investment Experience
We all want to make decisions to achieve what we believe
will be best for us, and there are many theories about how
we ‘should’ rationally make these decisions. However, there
is substantial evidence that the decisions we do make are
not the ones that these theories predict we would.
Studies by psychologists and economists suggest that there
are limits to the amount of information we are willing or able
to process. This leads to individuals using ‘heuristics’ or ‘rules
of thumb’ to help make better decisions. Many of these
‘heuristics’ lead to decisions that are almost as good as
those reached using the best rational option, and often re-
quire far less effort.
Unfortunately heuristics reduce the information that
individuals feel it is necessary to seek out before they make
their decisions, and can often develop into habits that don’t
easily fit changing situations. They don’t provide the right
answer in every situation. Additionally, people will continue to
use heuristics that have resulted in good outcomes in the
past. This tends to lead to a degree of overconfidence in the
outcomes of decisions when the particular heuristic is used.
How you ask is sometimes more
important than what you ask
Individuals are extremely sensitive to the way in which
decisions are presented or ‘framed’ – simply changing the
wording or adding irrelevant background detail can
dramatically change people’s perceptions of the alternatives
available to them, even where there is no reason for their
underlying preferences to have changed. Consequently the
framing of questions can often influence the decision that is
made. Consider the options in the problems below:
Problem 1
The government is preparing for an outbreak of an unusual
disease, which is expected to kill 600 people. Two alternative
scientific programmes to combat the disease are presented,
together with estimates of the consequences.
Which should be pursued?
Programme A: 200 people will be saved.
Programme B: A one-third chance of saving 600 people, and
a two-thirds chance of saving no one.
The ‘half empty/half full’
principle
Experimental studies show that when people are presented
with Problem 1, about 70% choose Programme A. Most
people prefer to know that they will definitely save 200
people than take a chance that none will be saved. The real
insight, though, comes when we compare these responses
to those of a second problem:
Problem 2
The government is preparing for an outbreak of an unusual
disease, which is expected to kill 600 people. Two alternative
scientific programmes to combat the disease are presented,
together with estimates of the consequences. Which should
be pursued?
Programme X: 400 people will die.
Programme Y: A one-third chance that no-one will die, and
a two-thirds chance that 600 will die.
The effects of framing can be equally dramatic in an
investment context. People’s personality traits can hugely
affect the way they react to the actual performance of their
portfolio in the future.
Consider a situation where two investors (Paul and Peter)
have made the same investment. Over one year, the market
average rises 10% but the individual investment value in-
creases by 6%. Paul cares only about the investment return
and frames this as a gain of 6%. Peter is concerned with how
the investment performs relative to the benchmark of the
market average. The investment has lagged behind the
market’s performance and Peter frames this as a loss of 4%.
Which investor is likely to be happier with the performance of
their investment? Because of the way that individuals feel
losses more than gains, Paul is much more likely to be happy
with the investment than Peter. Their differing reactions here
will frame their future investment decisions.

Another problematic heuristic is the strong tendency for

It should be fairly clear that both problems lead to exactly
individuals to frame their investments too narrowly – looking
the same outcomes but that one is expressed in lives saved
at performance over short time periods, even when the
and the other in lives lost. Therefore, if people prefer
investment horizon is long term. People also struggle to
Programme A in Problem 1 they should also prefer
consider their portfolio as a whole, focussing too narrowly on
Programme X in Problem 2 – these two choices lead to
the performance of individual components. Examples of
exactly the same outcome, 200 people being saved and 400
these important types of framing are included in the
deaths. However, when experimental subjects are presented
following section.
with Problem 2, only 20% choose Programme X! It shows
how easily people’s intuitive choices can be affected just by a
simple rephrasing of the options available.1
1
Source: Tversky and Kahneman, 1981.
Keep a broad perspective
“Mental accounting” refers to how individuals mentally
integrate different parts of their wealth. For a portfolio to be
correctly aligned to your attitudes we at Barclays Wealth
consider all parts of your wealth, and all the assets you hold.
However, different components of your portfolio may have
quite different risk properties.
Consider the following simplified portfolio:
50% of the portfolio invested in a UK bond index.
50% of the portfolio invested in UK shares.
Suppose that in one year, the UK bond index increases in
value by 10% and the shares component of the portfolio falls
by 5%. Over the year the portfolio would have a 2.5% overall
return. However, mental accounting often prevents
individuals from looking at the change in their total wealth.
Instead, they evaluate each component in isolation, and
because they are prone to loss aversion they are likely to feel
the pain of the 5% at least as keenly, if not more so, as the
pleasure of the 10% gain. (Psychological evidence
suggests that most people feel the pain of a loss about twice
as much as they feel pleasure from a gain of the same size.)
So, even though overall you are 2.5% better off than when
you started, you are likely to feel worse off than if that 2.5%
gain hadn’t included a loss. The result is that people often
take on less risk than is appropriate because they try to avoid
losses to any single part of their portfolio, rather than
focusing on overall performance.
Over-monitoring performance
can be misleading
How frequently you monitor your portfolio’s performance can
bias your perception of it. Suppose you were investing over a
5-year investment horizon in a high-risk equity portfolio.
The table below presents how you would perceive the
portfolio depending on the monitoring period.
Over the appropriate 5-year time frame, equity performance
has been positive 90% of the time, and so risky investments
do not lose money more than 10% of the time. However, if
you were to monitor the performance of the same portfolio
on a month-by-month basis, you would observe a loss 38%
of the time! 2
Once again, because of our inherent aversion to loss,
monitoring your portfolio more frequently will cause you to
observe more periods of loss, very likely feel more emotional
stress and take on less risk than is appropriate for your
long-term investment objectives.
Monitoring period
Percentage of 5-year period 1-month period
time seeing
Gains 90% 62%
Losses 10% 38%
Observing short-term fluctuations in the value of an
investment is likely to cause more discomfort for investors
who are particularly sensitive to losses. This may prevent
them from investing in such a portfolio and thus lose out on
the higher potential returns that they would get by taking on
appropriate levels of risk.
2
Source: Kahneman and Riepe, 1998.
Regrets of omission
and commission
Which would you regret more – having missed the
opportunity to buy a stock which went up by 45%, or having
sold the same stock before it went up? People who don’t
usually take risks fear errors of commission, i.e. mistakes
because of their actions. Conversely, individuals who have
experience taking risks worry more about errors of omission,
i.e. having the chance to make a good investment and
missing it. It is important to recognise that they have the
same effect upon our wealth, and we should keep a broad
perspective on such decisions.
Because of inflation, small
increases in wealth are
actually ‘losses’
Whilst we understand you want to preserve your wealth, we
all have a natural tendency towards ‘money illusion’, that is,
taking amounts of money at face value without factoring in
the effects of inflation. This means that not taking on any
risk in your portfolio can actually be risky. Holding your
money in a simple savings account is likely to beat inflation
by barely 0.5% over the next five years. At this rate, £100
kept in a savings account for the next five years will purchase
only £102.50 worth of goods when you withdraw it, even
through the nominal value will be in the region of £116.
In fact, the inflation rate calculated by the government
explicitly excludes affluent families from the methodology.
Many of the goods that wealthier people spend large
portions of their money on are increasing in price much
faster than the rate of inflation. School fees, insurance and
high-end entertainment are increasing by about 7 to 10%
per year rather than the 2 to 3% of the reported inflation
rate.
Your investments need to work even harder to keep pace
with your personal inflation rate and preserve the
purchasing power of your wealth.
If you are holding large portions of your wealth in cash or
very low-risk investments, your wealth may appear to be safe
when compared to the widely reported Consumer Price
Index (CPI) number. However, if, as is likely, your personal
inflation rate is considerably above the CPI, your wealth will
actually be losing value over time. Barclays Wealth can now
provide its UK Private Bank clients with access to a Personal
Inflation Rate calculator, which has been independently
developed by Ledbury Research. This tool can provide you
with an accurate assessment of the inflation rate that you
face across the range of goods that you purchase. This
provides an important guide to the level of returns that your
investments need to achieve just to preserve the spending
power of your wealth over time.
People divide their wealth
equally into smaller pots
When presented with a range of investment options, it is
common for people to use the simple decision rule of
spreading one’s wealth equally amongst the available
options. As with many heuristics, this is often a sensible
approach as it diversifies the portfolio, obeying the old rule of
thumb of not putting all one’s eggs in one basket. It also
helps us to overcome uncertainty about our own preferences
for risk and future returns as it is very difficult for us to
accurately assess how we will feel about a whole range of
possible outcomes in the distant future, and what our own
trade-off between the risk of future loss and higher returns
should be.
So when deciding how to invest, individuals often place an
approximately equal amount of their wealth into each
investment. However, this also means that the final level of
risk they take on can be heavily influenced by the number of
options they are presented with, i.e. the number of available
baskets for their investment eggs.
For instance, an investor who has five investment options to
choose between may be likely to place one-fifth of his total
investment in each. Thus, if presented with four risky options
and one safe option, the overall portfolio will be fairly risky. If
the investor were instead presented with four safe options
and one risky option, the final portfolio chosen would very
likely be fairly safe – regardless of the actual Risk Tolerance of
the investor.
A properly balanced portfolio will lead to portions of wealth
being spread across a range of assets but would be highly
unlikely to place equal amounts in each. Our Risk Tolerance
scale is designed to overcome the potentially harmful traps
that we are naturally prone to in our decision making. In
determining an accurate measure of your Risk Tolerance at
the outset, we can help ensure that your portfolio takes on
the right level of risk no matter what options you are faced
with.
Overconfidence leads to too
many trades
Another decision-making bias that humans are prone to is
overconfidence. Psychological studies show that, although
people differ in their degrees of overconfidence, almost
everyone displays it to some degree. For example, much
more than half the population claim to be above average
drivers, or have an above average sense of humour! There is
a tendency for individuals to place too much confidence in
their own investment decisions, beliefs and opinions.
In finance this can lead one to form firm opinions about
where the markets are going on the basis of far too little
information. Asset values tend to have an underlying
trending path but from day-to-day they often move around
in an unpredictable manner. Overconfident individuals take
the unpredictable movements in asset values as affirmation
of their own financial beliefs, and tend to see them as signs
of future trends, rather than just random fluctuations. In
many ways this is natural – people are psychologically
hard-wired to find patterns in the world. This frequently
leads to individuals over-trading because of the random
movements in asset values rather than the underlying
fundamentals that determine those values.
For active investors this often manifests itself in making too
many trades. Individuals will tend to believe that their
interpretation of information in the market is correct, even if
in reality it is based on observations of random fluctuations.
If the trades are based on overconfidence and random
signals, then on average they will tend to go neither up nor
down. However, each of these trades costs money, so on
average, over a large number of trades, overconfident
investors lose money. Investing for the longer-term is
frequently a better overall strategy.
The solution to this problem – and the others that we have
highlighted – is a portfolio which reflects your personal
investing preferences and which helps you avoid the
psychological pitfalls which all of us are prone to. As a wealth
manager, we believe it is our responsibility to make you
aware of these traps and how you can avoid them.
Ultimately, investment decisions – like all decisions in life –
are subject to our own particular biases and traits. We
believe that recognising these biases and traits – and taking
measures to avoid some of the most common pitfalls –
results in a significantly more enjoyable and rewarding
investment experience.
Legal note
Whilst every effort has been taken to verify the accuracy of
this information, the information, opinions or conclusions set
out in the report are intended solely for informational
purposes, and are not intended to be a solicitation or offer, or
recommendation to acquire or dispose of any investment or
to engage in any other transaction, or to provide any
investment advice.
Barclays Wealth is the wealth management division of Barclays and operates through Barclays Bank PLC and its subsidiaries.

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February 2008.