Debating behavioural finance

Debate concentrates the mind. It is easy to dismiss opinions you disagree with from the privacy of your own living room. Debating articulate exponents of contrary views is another matter – even more so when the discussion takes place in front of a large audience.

I found myself in the position of having to sharpen up my arguments for a recent debate on behavioural finance at the City of London festival (plugged at the end of my last blog post). An edited version of the debate was broadcast in the Radio 3 Free Thinking slot and is available to listen to online here.

Instinctively I was suspicious of behavioural finance beforehand. I was familiar with respected pundits, such as Dan Ariely and Richard Thaler, who were all too ready to dismiss human beings as scarred by irrationality or condemned by frailty.

Such contentions did not accord with my experience or understanding of humanity. We may not be perfect but it seemed to me that from the long-term perspective of human history we have achieved a huge amount over the years. We have literally moved from living in caves to, at least relatively speaking, hugely more prosperous, technologically advanced and even humane societies. Such progress would not have been possible without the operation of considerable powers of human reason.

However, reading some of the more subtle material, and debating the likes of Greg Davies of Barclays and Frances Hudson of Standard Life Investments, made me realise that the more moderate proponents of behavioural finance have a point. It is not that we are irrational but we do have what could be called cognitive biases.

For example, most people, given the choice, would evidently opt for having £100 today rather than £102 tomorrow. This is despite the fact that – except in conditions of hyperinflation – £102 tomorrow would be worth more.

To my mind this is not irrational but it is significant. We may, for instance, prefer £100 today because we are sceptical about being given it tomorrow. Perhaps the donor will run away or simply forget. Or we may have an urgent spending priority. Preferring the £100 represents a bias on our part but it is overstating the case to condemn it as irrational.

This example may appear trivial but there are many others that could be given. For instance, the common human preference for avoiding losses over making equivalent gains; or our underestimation of the effect of compound interest on investments.

Nevertheless it still seems to me that what might be called the strong form of behavioural finance is fundamentally flawed. In our debate this perspective was represented by Adrian Wooldridge of the Economist. His approach was essentially to run through a catalogue of financial bubbles over the years as a way of demonstrating innate human irrationality.

To me this approach is deeply ahistorical and superficial. It ignores the specific factors driving each bout of volatility and simply asserts that human irrationality was to blame.

In any case the debate, or at least edited highlights, are available to listen to on the BBC website so you can judge for yourself.

This blog post was first published today on Fundweb.