The past several decades have produced countless articles on the topic of “behavioral finance.” But what exactly is behavioral finance? This field examines how people make decisions with their money. It identifies things like patterns of incorrect thinking and predictable mistakes.
Most authors writing about behavioral finance focus on you, the retail investor. But have you ever wondered how the very same biases that plague the average person could affect your financial advisor? Could financial advisor biases affect your investment?
Behavioral finance biases can affect your portfolio in many ways, from advisors avoiding or underestimating risk to making decisions based on a “hunch.” Below are six types of biases that may affect your advisor’s choices—and your portfolio.
Overconfidence bias shows up in the fact that most people consider themselves “above-average drivers.” Unless you live in Lake Wobegon, this cannot be true. An advisor with an overconfidence bias could fail to adequately consider risk or might push you toward making a hasty commitment. They may refuse to consider your objections seriously. You will want to slow the pace of this kind of advisor to understand exactly how the recommendation traces back to your needs.
This type of bias means doing the same thing as others simply because they are doing it. After all, it’s more reassuring to be part of a group. Ask where your advisor gets information to support investment recommendations. Is it from the news or the popular financial press? If so, there is a risk that the recommendations you receive are just an attempt to keep up with what’s in style right now. Instead, a really good advisor will carefully weigh the pros and cons while also considering your needs. This way you stick to a strategy even if the market temporarily moves out of sync.
In behavioral finance, loss aversion describes how people tend to avoid taking losses because the pain of regret greatly exceeds the pleasure of gain. When your advisor hangs onto a fund with consistently bad performance, loss aversion could be to blame. Of course, that is not always the case. But if an investment shows little sign of being competitive with another equivalent choice, consider whether the need to avoid booking losses is preventing your advisor from moving on.
Confirmation bias is the tendency to look for information that supports rather than challenges previously held beliefs. It’s what people often do during political conversations. Your advisor may have decided long ago how the market is likely to play out and thus focuses attention only on the charts and articles that support that viewpoint. What you really want to see is careful consideration of multiple opinions to make sure that no important information was missed. An investment committee may be less likely to succumb to confirmation bias than an advisor who is operating alone.
This bias refers to our tendency to buy what we know. Does your portfolio display an emphasis in any particular industry or region? If so, ask your advisor why. Some advisors are experts in a particular area and base their investment strategy around this expertise. That can be valuable. But there is also the risk that heavy investments in a certain area of the market based on subjective experience, or what was successful in the past, just feel safe to your advisor. In long-term investing, you generally want a diversified portfolio even if it takes you and your advisor out of your respective comfort zones.
Heuristics are mental shortcuts. The human brain cannot possibly process all available data before reaching a decision; but even so, some shortcuts are just lazy. Heuristics may be at play if your advisor quickly decides on the merits of an investment because of a “hunch.” Or perhaps your investor responded positively to a brief sales presentation by a fund company. If so, beware. Hunches can go horribly wrong, and salespeople are not paid to present balanced information about risks and rewards.
Instead, inquire into how your advisor researched and decided upon the fund—this process is known as “due diligence.” Ask about what other funds they considered. Find out how they reached a final decision on the merits of the investment.
You get the idea: Behavioral finance biases that affect retail investors can potentially apply to your advisor. It pays to read up a little on these types of biases and ask some pointed questions. However, a few other issues that don’t necessarily show up in the behavioral finance literature might affect your advisor.
Advisors’ paradigms frame how they think about markets. It’s best to have that paradigm spelled out in a set of investment beliefs. This helps you ask questions and critique the basic assumptions your advisor brings to the investing process. For example, if your advisor believes value investing outperforms growth investing over time, this belief will inform future decisions. Even something as basic as stocks outperforming bonds over time is part of a paradigm. Nothing guarantees this will always be the case.
Some advisors use a lot of empirical data to support their investing paradigm. This is admirable and can provide comfort during the decision process. But investing is not a science like physics, with (mostly) immutable rules. Human behavior comes into play, and nothing is guaranteed to work all the time. You may not have a long enough investment time horizon to benefit from the average long-term trend. Worst of all, an advisor with too much data can become very rigid and perhaps even more overconfident than an advisor working based on hunches.
Finally, your advisor’s early training probably has likely set in place some views that will prove hard to shake. An advisor who came up through a full commission brokerage might focus on finding strategies that will sell and rely more on expensive actively managed products even if these don’t tend to perform well. On the other hand, if your advisor came up through a large discount brokerage, the bias might be reversed, with almost no consideration given to possible active funds. The exact period in the market when your advisor first started working with investments can also bias him or her to basic optimism or pessimism. Speak with your advisor about these things to be sure you truly have a good fit.
Because returns are never guaranteed, you have to learn what you can about your advisor’s process. Is it sensitive to your needs? What is the due diligence approach? What information sources are used? Your overall knowledge of how behavioral finance biases might affect investment recommendations is key.
If you don’t feel comfortable with your advisor’s transparency, keep looking. Many highly qualified advisors understand and can elaborate on behavioral biases. The honest ones will admit to having their own biases. And the best ones will have a process for managing them. Don’t settle for less.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: All About Asset Allocation and Due Diligence Before Investing. This is an updated version of an article originally published on September 20, 2017.]
©All Rights Reserved. April, 2020. DailyDACTM, LLC d/b/a/ Financial PoiseTM
CIO | CCO | RIA | Portfolio Manager | Operations | Compliance | Private Equity | Consultant Strong background in client service, investment research and management, client communications, operations and compliance within the registered investment advisor (RIA) space. Six years registered representative with a major brokerage. Six years leading investment department of a major financial…
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