Taming the pound

People advising on finance are supposed to “know the customer”.  They should find out your goals, what your attitude to risk is and so on.   That may be tricky, since you probably don’t know what your values and goals are yourself (unless you’ve spent a lot of time on this site!) so how are they going to find out?  And if neither of you know exactly what you want, when you want it and what you’re prepared to do to get it, how can they work out your “attitude to risk”?

But they are supposed to “know” you, so they may give you an, “attitude to risk” questionnaire.  That will allow them, in theory, to categorise you as a “cautious” or “aggressive” investor and various other descriptions.  Once you’re in categories of “risk profile”, the theory says, the advisor can steer you towards an investment that is “appropriate” to your “risk profile”.

You might know about framing effects – the classic example being a game show where you are offered choices.  Imagine, instead of a game show you are talking to your stockbroker, financial advisor or bank manager.  You want some information about an investment.

Even if you know what risks you are prepared to take, the way they phrase their questions (or the ones in their questionnaire) about risks will affect your answers.   For example, if they say – “this is 50% likely to gain you money over 3 years” – you’ll have a different reaction to whether that is acceptable to you than if they said – “this is 50% likely to lose you money over 3 years”.

Both of them are logically the same, but you’ll come out as a “different” risk profile depending on how they ask the question.

Unless advisors actually know what is going on psychologically, as well as financially, it’s hard to see how they are going to be able to give you the best advice.

Of course, you can hope that the regulators will actually understand this and make sure the psychology is included in the training for Financial Advisors.   Bearing in mind the pensions mis-selling, endowment scandals and all the other problems that went on for years before the regulators realised the problem that was going to happen because of their inadequate rules, how much of a gamble do you want to take on the regulators keeping you safe?

Imagine this:

You’re a contestant in a new game show.  You’ve already won £1,000 and you have two options. 

A) You can take an additional £500 and walk away. 

 B) You call the toss of a coin.  If you call right you get an extra £1,000, if you are wrong you get nothing extra. 

Make a note of which option you would choose.

Now read the second option.

Again, you’re a contestant in this new game show.  You’ve already won £2,000 and you have two options. 

A) You can lose £500 and walk away. 

B) You call the toss of a coin.  If you call right you lose nothing, if you are wrong you lose £1,000. 

Make a note of which option you prefer this time, before you read on.

If you are like most people (about 70-80%), you will have chosen option A in the first situation (you wanted the certain gain of an extra £500, giving you £1,500 in total) but in the second situation you chose option B (an even chance to lose £1,000 or to lose nothing at all, giving you either £2,000 or £1,000). 

You may have noticed that in both cases, by choosing option A you end up with £1,500 and with option B you end up with either £1,000 or £2,000.  So, logically, you “should” choose either A or B in both situations, depending on whether you would take a gamble or not.

This is an example of the “framing effect”.  If it is framed as a gain, most people want security, they take the certain gain.  If the situation is framed as a loss, most people will take a risk to try to avoid loss. 

Even if we don’t know the precise odds (as we don’t in real life), generally, people are “loss averse”, they don’t want to take a loss and would rather gamble in the hope that they won’t have to. 

Logically, that shouldn’t happen.  But human beings are human, they are not Vulcan’s and they are not logical.  You can try to be something other than human if you want, but it isn’t going to work.  It  works better to learn to deal with the facts, which are that you are almost certainly loss averse and you are probably influenced by framing effects, than it is to try to do something that isn’t possible, to be a Vulcan.

There’s a theory that if we teach people about the technical side of finance, increase their “financial capacity”, that will help people.

Say we apply it to archery.  Imagine masses of people in a field.   With them is archery equipment, so there are various bows and arrows in different materials, lots of archery aids, telescopic sights etc.  Also there are many expert archers to teach people how to shoot.   

The other things in the field, and around it on the surrounding hills, are many archery targets, representing the things people want from life.

The “capacity” idea is that we need to teach archery.  Everybody should know the tensile strengths of materials, understand hysteresis loss and aerodynamics, optics and air friction coefficients.  Then they can shoot accurately. 

I think it would be better just to take off people’s blindfolds! 

Sorry, I didn’t mention that the crowd all wear blindfolds.   In fact, so do the expert archers.  If we teach everybody how to shoot arrows and leave the blindfolds on, they might become good archers, but will kill one another by accident and won’t hit their targets because they don’t know what or where they are. 

Take off the blindfolds and let people see the targets.  Then they might decide that they don’t need a bow at all, they can pick up an arrow, walk two paces and stick the arrow in the target.  If the target is half a mile away on the hillside, then they need to get the right bow to fire that far, and the expert archers  can help them choose and learn to fire the appropriate bow to hit the target they want to hit.

Tell me, why would you want to learn all about bows, when what is important to you is your own target?

There’s lots of evidence that we aren’t rational with money.

Many people writing about money and psychology think people “ought” to be more rational. Actually, it isn’t as simple as that, there are at least three problems with it

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First, sometimes it would be better to be more logical, but in other cases we’re better off making “gut instinct” decisions, as in this book.

Second, no decision is wholly rational or emotional.  Have you ever had the feeling somebody was watching you? That is an observation that you’ve made sub-consciously, it is a thought, a bit of a logical process and the first thing you’re conscious of is a feeling.  On the other hand, you can often take a sub-conscious dislike to somebody, but the first thing you notice is something “rational”, like they seem argumentative.  It’s an emotional reaction but the first thing you notice is your “logical” conclusion.

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Feelings and thoughts are not easily separated, and one isn’t necessarily better than the other, among other things because both take part in nearly every decision.  There’s a whole book about it, which shows among other things what happens if we lose the “intuitive” and “emotional” sides of brain and try to work only on logic.

And if somebody tells you, “ah, but you should use logic and balanced rational thought, ignoring emotions for important decisions”, ask them what is more important than choosing a mate.  Follow that up with asking them whether they objectively evaluate each facet of somebody’s personality, logically balance good against bad and make a rational judgment of the ultimate utility of the action every time they are considering asking somebody out! 

Those are reasons why logical isn’t always applicable.  The third issue is that whether we “ought to” or not, we don’t have a choice. There is a really good reason why we don’t stop to be “rational” most of the time – it’s because we can’t.  We didn’t evolve that way by natural selection.

We are basically hunter gatherers in our brain and emotions.  Imagine you are out hunting or gathering.  The grass moves and it isn’t the wind, you think to yourself.  What do I want to do about it?

The main options for “what do I want to do” are:

√ I want to eat it.

√ I want to prevent it eating me.

√ I want to mate with it.

√ I want to fight with it for the right to mate with somebody else.

√ I want to cooperate with it to, hunt/gather/mate with/fight-off something.

That’s pretty much it. Now, think about it, do you want to draw up a table and calculate probabilities of each option, based on your perception of the size of the grass movement and an estimate from that of the size of the object, and work out each options value to you in terms of how hungry you are, whether you currently have a mate, your strength (and consequently your chances of fighting off a predator or competitor) and so on?  Of course you’ll still have to assign values to everything from the estimated size and consequent danger posed by different predators, your own strength relative to a range of different opponents, your charisma if it turns out to be a potential mate and so on. 

So you have to guess at lots of unknowns, and then fit them into a formula, then solve the formula (all in your head) and then you have to go with the final probability estimate. 

If you did want to do all that, I’m afraid you’re too late.  Here is what happens.

We’re all the descendants of people who made decisions in time.  The people who didn’t make their minds up fast, died.  If they died they didn’t have many offspring. 

Humans were bred to make quick decisions.

The environment humans developed in shapes the way we are. Not just our bodies (like walking on two legs instead of four) but how we think and feel as well.  

Some people talk about “social Darwinism”, meaning that we adapt all the time and that society changes us.  But natural selection doesn’t work that way.  It works through reproduction, which means it takes thousands of years to make a difference (about 11,300 years  – if you want to check, have a look here). [amazon-product]0691029059[/amazon-product]

People have been around in their current form for about 60-70,000 years (depending on who’s figures you believe for how old homo sapiens are). If you add to that all the years of previous hominids (like homo erectus, homo habilis and so on), we end up with something like:

Hunter-gatherers – about 1.75 million years

Cities – about 7,000 years

Banks – about 400 years

Welfare state about 50 years

Which environment do you think we’re evolved to deal with – what sort of “environmental selection pressure” formed the way we look, think, make decisions, register emotions? 

Right, hunter-gathering. 

We’re not “evolving” into different types of people. Socially, we might change a little.  For example, as hunter gatherers we might have killed outsiders.  They were a different tribe, who looked different and had a different accent and therefore were potentially dangerous. Nowadays we probably wouldn’t kill them, just laugh at their funny accent and odd colour skin, and refuse to have them in our club or our country!

It would take thousands of years for changes in our more basic functions, like emotions, thinking patterns and all the cues that make us distrust those who are different. It might be socially useful not to make snap judgments, but while we might adapt our behaviour (in the same way as refraining from killing an outsider) we don’t really change the fact that we do make very rapid decisions.

If we were going to change by natural selection, the environment would have to make the changes more successful for breeding.  So if money was going to make us “evolve” the wealthy would have to have more surviving children than the poor. There is no evidence that they do (and quite a bit that the poor have more children than the rich, bearing in mind ages at first parenthood etc.)

So the environment might have changed socially, but we don’t change fundamentally, we’re still well adapted to be good hunter gatherers, not to be good bankers.

The theory name always gets shortened.  More completely it is, “Evolution by means of Natural Selection”. The theory also applies to brains and emotions, not just bodies.

Genes try out different combinations pretty much randomly, since sexual reproduction, apart from being fun is a good way to mix up genes to try out new combinations.  Once you have a new combination (one that is based on the genes the parents have, which were effective enough to allow the parents to breed) that gets “tried out” in real life.

The genes might make somebody slightly smarter, or more stupid, than others, be more selfish or more altruistic.  They might make somebody analytical and not emotional, or the reverse.   And those genes, however they are manifested in us, are potentially passed on to our children, if we have any.

The environment then performs a sort of “Goldilocks” experiment on the results of the genes.  This person is too selfish, nobody likes them, nobody mates with them.  This person is too altruistic, everybody likes them they have lots of mates, but they give away all their food to the poor, and their children die of starvation.  But this person is just right – they are pleasant and helpful enough to be well liked, but they look after themselves and their offspring.

Therefore they have lots of children who survive and the genes that made them like they were get passed on to lots of people in the next generation.  Those children inherit the genes that made their parent so successful in reproducing.  So they tend to have lots of children too.

This applies to all sorts of thoughts, emotions, decision processes and so on, as well as physical characteristics like strength or eyesight.  Genes that result in the person they produce being more successful in getting food, mates and the other requirements of life (e.g. stronger bodies to hunt, nicer personalities to attract mates, larger brains to solve problems) or producing more and better offspring (e.g. emotions that lead to finding and keeping a better mate or protecting and feeding offspring so they grow up successfully) will mean that those people have more offspring that will grow up to have offspring of their own. The less reproductively successful people will have less offspring who breed, so over time, the proportion of the genes that produce successful people will increase in the population, while the genes the produce less successful people decline.

The population ends up dominated by people who have the most living children!

The “selection” is done by the environment.  It isn’t about being “nice”, “selfish”, “strong” or “rich” or anything else, it is only about what works to drive increased numbers of offspring in the environment – that is, what is reproductively successful in the real world.

Stephen Pinker has written a couple of books on this that you might like:

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