Saving Percy from himself

Stock exchange building, London. The UK Financial Conduct Authority is concerned that people aren't as price conscious with financial services as they should be. Photo / Getty

A couple of years ago the chief regulator of things financial in the UK was restructured so the Financial Services Authority (FSA) became the Financial Conduct Authority (FCA). The significance of this is that the FCA was given the additional objective and duty by parliament of "promoting effective competition". The FCA believes that competition should be based primarily on price and quality rather than "false focal points or strategies to exclude rivals at point of sale".

I'm not exactly sure what that last bit means but "effective competition" sounds like good stuff from the FCA and might be something the FMA looks at especially given, as we saw a few weeks ago, some local retail investors get badly ripped off by the local financial advisory industry. Retail investors tend to be far less price sensitive than institutional investors with the result that they often get ripped off.

The FSA had been criticised for not having had its act as together as it should have been and the FCA's new approach is already starting to become evident. The FCA's present focus is on ensuring that "the promise and delivery of financial products is closely linked", ie what you buy actually performs as it is supposed to. A good strategy but not really rocket science.

With this objective in mind the FCA published an interesting paper on behavioural economics. Before everyone rolls their eyes and thinks "oh god not another boring story on behavioural economics" the FCA's effort is different because, instead of rehearsing those theories we have heard a thousand times before, it acknowledges what everybody knows but no one is brave enough to say, that many consumers of financial services act, for one reason or another, illogically and do not put much effort into researching their investment decision and uses behavioural finance to do something about it.

The FCA is especially concerned that people aren't as price conscious with financial services as they should be. This is important because as this column has pointed out many times the average annual fees paid by retail investors to a full service financial planner in NZ, inclusive of fund manager costs, is such that it eliminates the risk premium which shares deliver over bonds. So what you get is the risk of equities with the return of bonds. It is the same situation in the UK.

In a speech to the London School of Economics the boss of the FCA spelt out this new initiative when he said that a significant challenge for modern regulators is to recognise that, whilst we work in an environment of ratios and complex models, decisions made by Mum and Dad are often flawed and that behavioural economics helps us understand why people do stupid things.

He said "there is a question of how a regulator navigates the balance of power between consumers and providers". He acknowledged that "caveat emptor" applies some of the time but suggested that it is hard to argue that unsophisticated Mums and Dads should have done due diligence when they are buying "seriously complicated financial products where the risk of failure is far more dangerous than a decision in the supermarket to buy three bananas instead of one".

This is an opinion that local fund managers, financial advisors and the regulator should take on board. For the avoidance of doubt : simple is good, complex is bad and low fees are better.

The FCA then went further by inferring that some in the finance industry exploit behavioural weaknesses and sell people things they do not need at prices they cannot afford.

So let's have a look at the "FCA's take" on behavioural economics. The FCA starts by observing that retail investors often make errors when choosing financial products and can suffer considerable losses as a result. No real surprises there but the FCA believes that by using behavioural economics regulators can understand how these errors arise, why they continue and consider what it can do to fix them.

The FCA also believes that some investment firms use product design, marketing and sales processes that exacerbate the effect of biases so as to make a sale. The FCA paper then sets out various examples of behavioural biases that act to impede good decision making.

First up was the behavioural bias of over confidence, defined as an excessive belief in one's ability to picking winning stocks. I frequently see an advert for spread betting in the London Financial Times which plays on this behavioural bias. It has a picture of a middle aged white male trying to look intelligent with a comment "I know what I am doing so I need up to the minute information" below his picture. Sure he does, probably bankrupt and divorced by now.

Another behavioural bias is "over extrapolation" which means looking at a couple of years of investment returns and assuming they will continue. This behavioural bias is exploited by many investment firms and whenever anyone tries to instill a sense of reality into the discussion the industry responds vigorously. I recall one fund manager's advert which trumpeted its return over one year. Ridiculous.

Yet another common behavioural bias is mental accounting and narrow framing. What this means is that investment decisions may be made on an asset by asset basis rather than considering the whole portfolio.

I have clients who become deeply despondent when something they own goes down in price so point out to them that their sense of loss would be justified if we had invested their entire portfolio in this losing position but fortunately that is not the case. I then point out that they have other investments that have done well then sarcastically observe that this is the nature of a balanced portfolio but doubt whether it cheers them up.

The narrow framing bias is often associated with the very common "loss aversion" bias where people don't like to sell investments at a loss. I recall one stockbroker handbook from the US advised trainee stockbrokers that in order to get clients to trade they should combine selling out a loss making position with the sale of another stock where the client had made a profit. Because the client would in his/her mind consider that the gain on one stock would offset the loss on another they would be more inclined to trade. Sneaky! In a previous life I used this technique myself and it works well.

This is good innovative thinking from the FCA and may have some application locally. In an interview with the London Financial Times the head of the FCA said that the FCA's chief objectives as to deliver a properly functioning market where properly functioning meant "profit for the good firms, exit for the bad ones and products that meet consumers needs". That strategy might even work in NZ.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have a financial interest in the companies mentioned in this article.