The role of behavioural economics in KIIDs

Lancaster, Phil_700x450

Freakonomics popularised the application of economic theory to non-traditional subjects, including drug dealing. When offered the chance to subscribe to a series of lectures on Social Economics while at university, I was expecting a crash course in similarly eye-catching titles.

Instead I was subjected to theories including The Economics of Brushing one’s’ Teeth and The Economics of Christmas. Plain speaking theory dictates that at Christmas, if your aim is to offer a gift that is the greatest value to the recipient, you should simply give money. I’m not sure everyone would agree.

The new Packaged Retail and Insurance-based Investment Products EU regulation is using behavioural economics to support the content and design of the new Key Investor Document for structured investments. We can look to the FCA for guidance into the role behavioural economics plays in KIDs.

A paper from 2013, Applying Behavioural Economics at the Financial Conduct Authority, calls on topics covered by notable economic theorists and commentators such as Adam Smith, Daniel Kahneman and Nassim Taleb, and considers how the FCA can design effective interventions to protect customers.

Concerns of fairness are at the heart of this FCA paper. We can make errors in making investment decisions, and many of which are due to personal biases around preferences and beliefs. The paper highlights the need for the FCA to ensure product manufacturers don’t unduly exacerbate biases and influence the decision-making process.

In Thinking Fast and Slow, author Daniel Kahneman considers how biases can arise and the FCA paper acknowledges his findings that people have two models of thought: an automatic decision-making process that relies on intuition, and a more reasoned analysis, which is comparably much slower at decision making. When comparing different investment options, we may fall back on and mistakenly trust our intuitions, which could be influenced by the way information is presented and because we have a limited attention span.

“It is often the most colourful displays for products that have performed well historically”

Priips regulation has outlined the need for KIDs to be no longer than three sides of A4 and how information is displayed is called “framing”. The European Commission has employed a contractor to undertake consumer testing to determine the effectiveness of various KIIDs. The aim is to standardise KIDs and ensure attention is not unduly drawn to certain aspects by the use of colour and layout.

The new KIID is formed of nine sections comprising: product type, risk and return profile, costs, and consequences of encashing the investment holding period, among others. Investors and advisers will place a greater emphasis on different sections in reviewing products, but benefits should not be unduly highlighted to underemphasise risks and costs.

Priips aims for greater transparency around costs, breaking them down to their components and describing the impact of recurring charges taken each year to compare costs over the intended holding period of the investment. Structured products however just have upfront charges.

In product literature, it is often the largest and most colourful display for products that have performed well historically. The new KIDs must show a forward looking view of expected per-formance, and not just in positive scenarios, but also give equal consideration to negative scenarios.

In The Black Swan, author Nassim Taleb noted how negative performance is more emotive than positive performance. His recommendation was to not look at performance frequently and to allow a longer-term time horizon to reduce the number of peaks and troughs seen, lessening our emotionally biased reactions. It will be interesting to note the time periods used to display historic and forward looking performance data when Priips compliant KIDs are published.

It is fitting that Priips comes into effect on 31 December. A bit like the Economics of Christmas, theory can support the content and design of KIIDs and try to mitigate behavioural biases of investors when making decisions. But the real need is to disperse the biases of some advisers, allowing structured products to be considered alongside alternative investments, putting aside biases and focusing solely on the facts.

Phil Lancaster is investment analyst at Lowes Financial Management