The most prestigious prize in economics, the Nobel Memorial Prize in Economic Sciences, was awarded this month to the American economist Richard Thaler, known for his ‘nudge’ theory and a leading light in the growing field of behavioural economics. James Lawson FRSA explores the extent to which the investment community has taken these arguments on board and the implications of doing so.
The real breakthrough in behavioural economic theory came 15 years ago when one of Richard Thaler’s peers – the Israeli-American psychologist Daniel Kahneman –proved that people deviate from economically logical choices for predictable reasons. By crossing into psychology, economics began to develop and become much more relevant. But how many of these lessons have been learnt by the investment community?
Not many. When investing, we are all happy with the concept that if you want more return, you need to accept greater risk. As a result, the focus of the investment industry has been seeking the best ‘risk-adjusted returns’ for their clients. And taking on more risk without expecting any additional return isn’t clever. But a portfolio with the ‘best risk-adjusted returns’ may actually be woefully incomplete in terms of what your best portfolio should look like.
Tribe Impact Capital, the UK’s first impact wealth manager, commissioned Greg Davies PhD, to try to understand why the risk-adjusted returns mantra might not be as universally suitable as we’ve been taught. In our paper, ‘Investing for Real People’, we found three lessons from behavioural finance.
- Firstly, total returns from investing are both financial and emotional. But traditional investment approaches usually ignore the latter.
- Secondly, money is a means not an end. But typically investing only sees it as an end.
- And finally, good investing requires emotional comfort. But traditional investing tends to ignore concepts like comfort.
But if those are the issues, what can we do about them?
Investments deliver two distinct types of return: financial and emotional. The latter is usually overlooked in traditional investment decision making; the value we get from owning something. This might come from a sense of satisfaction, enjoyment, or purpose. Collectibles are a common example: art investors may get a financial return from their holdings, but they will get an emotional return.
Impact investing is another example. These are investments that seek financial as well as social and/or environmental benefits. So a portfolio of impact investments can deliver financial returns and an emotional return from the sense of purpose that your portfolio is supporting.
Implicit in the drive to maximise risk-adjusted returns is the assumption that more money is always better. But more money is a means and not an end; it is only valuable because it helps us get more of what we want. There are a number of studies that show more money does not lead to more satisfaction.
Yet what if some of what we want can be acquired through the process of investing rather than the proceeds? Imagine that some of what you plan to spend your money on includes some social or environmental benefit: things that you care about. Impact investing, with both financial and social/environmental goals, can get some of what you want, even while making money to get you more of what you want.
The financially optimal portfolio may be right for a perfectly rational operator, but is seldom the best for a real person. Abundant evidence exists to show that uncomfortable investors make a myriad of poor decisions. For example, the behaviour gap occurs when our emotions get the better of us: we are greedy when markets are expensive and fearful when they are cheap. This bias costs the average investor 1.5% per year.
An investment portfolio that expresses your values, invested in businesses with stories that resonate with you, and that reflects your beliefs, is one you are comfortable with. This type of portfolio provides a natural emotional hedge to the stress of markets. So if you are rational enough to recognise some of the above, and human enough to realise it affects you too, you should start to think about the emotional return on your investments.
James Lawson is a co-founder of Tribe Impact Capital LLP, the UK’s first dedicated impact wealth manager. To request a copy of the paper that this article was based on, please contact Tribe via firstname.lastname@example.org