What a pair of high heels says about your spending behaviour

Should you be consulting a shrink instead of a financial consultant about your investments?

BY Jane Lewis LAST UPDATED AT 16:08 ON Fri 30 Aug 2013

APPARENTLY, women who go shopping in high heels make better buying decisions. Not, as you might think, because they're more likely to stop splurging and head home if their feet are killing them. But because they've got better balance. 

According to researchers at Brigham Young University, women in heels enjoy a "heightened sense of balance" physically – and that affects their mental processes. Strap on your Manolos and you're more likely to make a balanced decision and choose a sensible mid-range product.

It sounds like a classic silly season story. But it chimes with the current craze for "behavioural finance", which explores the impact of human psychology on financial decisions. Essentially, the theory homes in on the irrational tricks our brains play when we're thinking about money and risk. It argues that "homo economicus" – the rational wealth-maximiser who applies logic and reason to further his own financial well-being – doesn't really exist. He goes out and buys a lottery ticket instead.

To invest successfully, therefore, we must identify all those inbuilt prejudices and quirks ("cognitive biases" in the jargon) that drive us, but of which we are barely aware. Taken to the extreme conclusion, you'd be better off consulting a shrink rather than a financial advisor before make an investment decision.

Rather like sex (which began in 1963, according to Philip Larkin), proponents of behavioural finance like to give it a specific birth date. Most cite research conducted by the "fathers" of the school, Daniel Kahneman and Amos Tversky, which culminated in a Nobel prize for economics in 2002. Their work was seen as revolutionary, because it contradicted established "modern" thinking – typified by the Efficient Market Hypothesis – that investment decisions are made rationally.

Given the long and rich history of financial manias, from Dutch tulips to dotcoms, it seems obvious that downplaying the impact of human emotion on markets was always just so much tosh. Indeed, retailers have been profiting from customer irrationality for years. Bogof (buy one, get one free) is a neat illustration of how our love of a bargain overrides the more fundamental consideration that we didn't need the product in the first place.

So, what are the most common psychological investment pitfalls? A tendency to chase the latest fad because everyone else is doing so is right up there. So, too, is over-confidence in our own abilities. When an investment does well, we're far more likely to credit our stock-picking nous than any other external factor. And the converse is true if it bombs.

Another common trap is "loss aversion": you're about three times more likely to sell a stock that has performed well than one that has done badly – regardless of the fundamentals – because of an inbuilt reluctance to acknowledge the loss.

Another is "confirmation bias" – the tendency to look for information or evidence that supports your original investment idea, while filtering out anything that contradicts it. There are many more.

These theories are all very well, but are they of any practical use. Take chasing the herd. Even assuming you can discern which way it is running, it doesn't always pay to take the opposite direction. The old Wall Street adage that the "the trend is your friend" holds good at least some of the time – even if you're unpersuaded that it's rational. As Keynes summed up: "The market can stay irrational longer than you can stay solvent."

Then there is the difficulty of actually applying psychological insights. As Greg Davies of Barclays Wealth has noted, some biases will never be eradicated. "You're never going to solve the problem because you can't change human nature." He urges investors to "manage their inner selves" by writing themselves a "constitution" – including things like setting firm limits on how and when an investment decision is made.

It's easy to be cynical about behavioural finance, and the post-crisis obsession with hormonal glands (viz countless studies assessing the impact of testosterone on risk-taking). Indeed, there are plenty of economists who dismiss much of it as pseudo-science.

Certainly, the prospect of the fad running amok is nightmarish: it may only be a matter of time before your fund manager presents you with a Myers-Briggs personality test and insists on a blood sample to determine your hormonal make-up.

Still, the fundamentals of the theory seem sound enough. If you are aware of your biases, you probably will make smarter financial decisions. Investor know thyself – it's not a bad homily. · 

For further concise, balanced comment and analysis on the week's news, try The Week magazine. Subscribe today and get 6 issues completely free.