Described as the “invisible hand”, human economic behaviour supports the productivity of economies. Often driven by self-interest and the desire to maximise one’s own utility, the greater public good is often served by personal biases that unwittingly form the division of labour
and establish the market where we exchange the surplus part of our produce, for such parts of other people’s labour that we have the need of.
It is therefore incumbent on those involved in the financial services industry to identify and strive to mitigate the potential outcomes of negative financial behavioural biases in an effort to improve the financial wellbeing and outcomes for all participants.
Like the nudge of an invisible hand, behavioural financial biases can affect both cognitive decisions of clients along with their emotional responses. An efficient market system requires three components including, investor rationality, the consideration of information available and that the decision maker always pursues self-interest.
The outcome of this approach is the maximisation of utility and wealth. However cognitive biases can exhibit idiosyncratic behaviour in terms of perception and the unrealistic evaluation of reality. These are represented by the following.
Firstly, categorised as “belief perseverance” were conservatism,
confirmation, representative, control, and hindsight biases influence the decision maker.
Secondly, “information processing” biases for which anchoring, mental accounting, framing, and information availability contribute to financial decisions.
Thirdly, emotional biases affect the decision makers feelings, loss aversion, overconfidence, self-control, status quo, endowment, and regret.
Understanding the outcomes of these biases can provide insight into the investors’ confidence levels when making financial decisions, and the psychological make-up of the decision maker where losses carry more weight than equivalent gains.
Behavioural finance helps the investor or decision maker understand the difference between their expectations and what may be considered rational investor behaviour. The adviser/client experience as an outcome of advice is paramount to helping clients achieve their financial goals and be satisfied with the outcomes of the advice provided.
Understanding a client’s behavioural bias can assist in the determination of investor preference and behaviour particularly with regards risk profile assessments. Experience demonstrates that many investors complete risk profile questions from a conservative starting point, and view investment risk in terms of a catastrophic loss mentality. This may not be a surprise though considering many risk profile questionnaires focus more on “Loss Aversion” than they do longer term financial earnings.
Risk profiling focuses heavily on a client’s loss aversion, often reinforcing existing biases. The focus tends more towards short term losses and the frequency of losses rather than the reward expectation for taking on risk inherent in an investors personal time frame. When considered in isolation this does little to encourage the investor to take on sufficient risk as to grow their investment. They fail to address the real potential of compound losses or underperforming investment returns over time.
Focusing on loss as an axiomatic term of risk can reinforce contemporaneous decisions to the detriment of the long-term outcomes. People are motivated to pursue pleasure and avoid pain. The pleasure of the future is hard to reconcile against the pain of today and support the difficulty facing decision makers when trying to consider the long-term out can guide investors towards rational long-term decisions.
Advisers should seek to understand these biases and provide support to the decision maker on how to identify and address these anomalies. If for example the financial adviser or decision maker can understand that Millennials may exhibit herding behaviour, then they are potentially able to mitigate or reduce this bias. However, if the adviser and the client share the same bias then the outcome may be irrational or at least idiosyncratic in nature.
Culture can also play a part in financial behaviour particularly where the development of financial capacity is limited. Research indicates that women, the indigenous community, younger and older Australians can be at risk of lacking the financial skill to make informed investment decisions.
Unfortunately, this can make them vulnerable to act on bad or self-interested advice. Clients can also gravitate to advisers that tell them what they want to hear. If an adviser recognises a client’s behavioural financial bias, he may manipulate the conversation or represent the advice in such a way as to reinforce such biases to make a sale.
There are two strategies that focus on “debiasing “that include changing the environment to make the bias “irrelevant or mitigate its effect” and “modifying the decision maker”. It is not always easy for the decision maker to identify that they have a bias, or that such bias may produce adverse financial outcomes. It is incumbent on financial advisers to be aware that such biases exist and be aware of how to support the client in mitigating them.
The following are examples of behavioural financial biases and the methods that can be used to assist the decision maker to mitigate them.
Confirmation bias – seeks to confirm what the decision maker believes to be true. It can produce and increase in self-confidence leading to a false sense of security. Mitigating this involves challenging preconceived ideas and the status-quo of previous financial decisions.
Representative bias – judgements based on stereotypes and bias towards recent observations rather than longer term views. A belief is held that recent history can be representative of future returns. Mitigating this bias includes consideration of base-rate probability resulting from too much attention on short term results and insufficient focus on longer term track records. Being aware of statistical errors and challenging the sample-size where judgements are derived can assist in changing this bias.
Illusion of Control bias – leading to the potential for excessive trading or poorly diversified portfolios this bias can exhibit itself like overconfidence. To overcome this, the investor will require a conscientious approach to determine their reasonings and will potentially require external viewpoints that challenge their reasonings.
Anchoring bias – This bias works to “anchor-consistent information” in support of original values of information when making unquantifiable financial decisions. This bias is considered robust and difficult to overcome. However, reinforcing past performance as no guarantee of future returns and that such an approach should not influence financial decision making on whether to buy, hold or sell presents a starting point.
Environmental conditions are considered one of the greatest factors in the learning process. Creating an environment that assists the client discover for themselves what is in their own cognitive and emotional makeup, provides the foundation for change and highlights the critical role advisers can play in supporting their clients’ financial decisions through the need for regular ongoing reviews.
Establishing a clear and rational message over time can help the client see their own cognitive biases and learn to compensate accordingly. Rationality and consistency in the advice message assist the client to make improved financial decisions.
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