"The investor's chief problem - and even his worst enemy - is likely to be himself", investment guru Benjamin Graham once wrote.
He might as well have referred to “the human being’s chief problem”. Because when it comes to making long-term decisions in particular, the way our brains are wired can pose a formidable challenge.
For this we can blame the limbic system. This is the part that was 'acquired' at an early stage in our evolution as mammals and is responsible for what we call our emotions.
It also has a nasty habit of overriding the more evolutionary recent part of the brain - the cerebral cortex - that is responsible for logic and complex thought processes, with the result that we often favour short-term rewards over longer term objectives.
For a topical example we need only look at pension freedoms data on how many people have accessed their pot just to get their hands on the pension commencement lump sum (PCLS) and now find themselves in drawdown by default, or have encashed the fund in its entirety only to leave it in a low interest bank account.
So, we have something of an inbuilt disadvantage when it comes to making decisions about our long-term future.
There are sound evolutionary reasons why we respond to the immediacy of reward, but it really doesn’t stand us in good stead when we need to make provisions for increasing longevity. The role played by our emotional brains makes it difficult for us to imagine the future even when we can understand how our actions might have long-term consequences.
“Our emotional brain wants to max out the credit card, order dessert and smoke a cigarette,” according to Harvard University Professor David Laibson. “Our logical brain knows we should save for retirement, go for a jog and quit smoking."
There’s a raft of research out there on the various behavioural and cognitive biases that can result in logic coming a distant second to emotion. Daniel Kahneman and Amos Tversky’s Prospect Theory, for instance, found that investors usually feel the pain of losses more intensely than they do the pleasure of gains of the same size, the outcome typically being risk averse behaviour that’s out of proportion to the expected outcome.
What does all this mean for advisers? Well, it will often be the adviser that has to protect clients from letting their ‘emotional’ brain undermine their chances of building and maintaining a sustainable pension pot, for example.
You can tell a client everything you know about the concept of risk and reward and even set out what different trade-offs can mean for their long-term outcomes. But it might not mean much when confronted with emotional needs and impulses.
Fortunately there’s now a wealth of tools and visual aids to help with this, as technological innovation helps to simplify financial information and map out decision making processes.
Combined with a human element that prepares clients for the emotional ups and downs of their investment journey, we can give logic a fighting chance and prevent our ‘emotional’ brains from wreaking havoc on our future finances.