One of the most important reasons for using a financial adviser is that it protects the investor from his or her own behavioural biases. Poor investor behaviour, even more than fees and charges, is a key contributor to disappointing returns and, by helping clients to avoid pitfalls such as trying to time the markets or chasing performance, advisers can add significant value over time. Vanguard has estimated that, on average, good behavioural coaching adds around 1.5% a year.
There is, however, a caveat: investors only receive the full value of behavioural coaching if advisers themselves do not allow their own biases to affect their clients’ outcomes.
So, what evidence is there on the ability of advisers to identify and control their own biases?
This question was addressed in a recent book by H. Kent Baker, Greg Filbeck and Victor Ricciardi called Financial Behavior — Players, Services, Products, and Markets. The authors have also published a paper in the European Financial Review which highlights some of their key findings.
“Financial planners and advisers,” the article states, “reveal a wide array of psychological biases that can result in flawed judgments and decisions.”
Baker, Filbeck and Ricciardi have identified several areas in which adviser behaviour can detract from any value they provide, of which these are the five main ones:
Advisers who use heuristics, or mental shortcuts, to help them process large amounts of data, are prone to excluding specific information or processing information incorrectly.
Like individual investors, advisers often base their decisions on the first piece of information they receive and subsequently find it difficult to modify their initial assessment in the light of new information.
Ideally, advisers should assess financial risk, and the relationship between risk and return, using purely objective criteria. However, research has shown that subjective actors such as heuristics and worry typically play a part as well.
The authors also found that, when choosing what to put in a client’s portfolio, advisers have a preference for assets that they are familiar with; for example, many tend to overweight domestic stocks.
Finally, it’s not just clients who worry; their advisers do too! The more worried an adviser is, the more likely they are to focus on past decisions that had negative outcomes, and the more risk-averse they are likely to be.
What, then, are the lessons to learn from this research? For investors, it’s important to remember that although, on balance, you would expect financial professionals to be better equipped than you are to control unhelpful biases and to keep human emotions in check, advisers are not immune self-defeating behaviours.
For advisers, the lesson is to be as mindful of your own behaviours, moods and emotions as you are of your clients’. Remember, too, that if you’re outsourcing investment decisions, then those third parties are also prone to poor behaviour. Either way, there is much to be said for having a simple, rules-based and automated investment process that keeps human decision-making to an absolute minimum.
Here is the paper in the European Financial Review referred to in this article:
How behavioural biases affect finance professionals (Baker, Filbeck & Ricciardi)
You may also want to read the following:
Shocking news — you and your adviser are biased (Hugh Massie)
Behavioural biases of investment advisers (Antti Seppälä)
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