When Behavioural Biases turn away from the simple truth; what do you think happens to financial decision making?

Long-term financial planning is extremely important for lifetime financial security, but it is also exceptionally difficult for most investors.

By improving decision making among clients, financial advisors can improve lifetime financial security.

The average investor is less knowledgeable than professionals about the problem and has limited time and attention to devote to it. Understandably, investors may resort to rules-of-thumb, display biases, or behave “irrationally” in other ways. Not only does this make optimal long-term financial planning difficult for the average investor, but it presents challenges for advisors as well.

behavior bias

Advisors must be equipped to handle emotional and financial biases of their clients leading to a more productive relationship.

Below are some of the biases seen and experienced among planners and clients.

Over Confidence:

Client Asks: What is your estimate of the market 1 year from today.

Sounds familiar?­

Estimates on  Inflation, Interest rates, pricing of stocks, monetary policy and even Government decision making is asked to the planner.

Clients and Advisors, make judgements based on assumptions on a variety of factors. The outcome of which would be higher than actual, or lower than the actual or within reasonable limits of predictions made.

Statements of Over- confidence, could lead to mis-representation of facts.

Bold Statements if fulfilled, will keep clients happy, but failure to live up to them would haunt the advisor and make, an unhappy client.

Optimism:

People are generally optimistic of their capabilities. Optimists underestimate the likelihood of bad outcomes and this could be dangerous.

We are only correct about 80% of the time when we are “99% sure, according to a study.

Optimists are prone to an illusion of control. They tend to under estimate risks, and over estimate returns.

What should advisors do?

When making recommendations based on historic movements, resist the temptation to focus on the upside.

The Advisor should make a list of the recommendations that went wrong. Such examples can be referred to in the future.

This would help not only the client, but the advisor, to keep in check his/her optimistic forecasts.

 

Over reaction to chance events

The human mind thrives on pattern seeking. If a fund manager has continuously been providing above average returns, all eyes are on him/ her and this leads to overreaction from investors and advisors of the slightest negative information or performance the fund shows.

In Financial Plan preparation, an advisor, should use “What if Analysis” that will provide different perspectives to time horizon, value, inflation, interest rates, returns and market cycles to help clients understand various scenarios, so as to keep them updated on a variety of outcomes.

Value Function:

People attribute more aversion to “loss” than “less gains” made on a portfolio or stock.

It is important for advisors to note this, especially, for risk-averse clients.

Also, when it is time for us to act upon facts and data gathered by financial advisors, optimism and loss aversion biases comes into conflict.

As a result, advisors and investors, tend to make bold forecasts, but timid choices, when it comes to actual execution.

This is where a useful risk tolerance questionnaire helps and probably a re-look of the same once a year or when there is a major change in the situation of a client.

Also, a regular update and in-depth report on market trends, with possible volatilities, is important to communicate with clients on a regular basis, to pacify their fears.

 

Herd Behaviour

The advisor is all prepared for a goal review with the client, based on client-specific investment needs and goals.

However, right from the start of the meeting, the client starts talking about which stocks or sectors his friends are investing in and what are we doing about replicating the same in his portfolio.

At such times, referring to the investment policy statement, specific to the client, and highlighting the risk-return trade off and goals, should be highlighted.

Showing on track progress of goals might alleviate the situation.

Also, in the Client Questionnaire, if the same kind of question is asked: if the client will jump the wagon to go for what’s “in” or continue with the plan laid out by the planner, will be of help to highlight the same to clients in such circumstances.

Purchase price as a reference point:

If, for example, Investor A has purchased a stock at Rs 100 and Investor B has purchased the stock at Rs 200.

If the value of the stock falls to Rs 150 , who do you think will be more upset?

Investor B for sure. His starting point or purchase price is the reference to determine the loss or gains made in an investment.

For A, it is a reduction in gain, where as for B it is an instantaneous loss.

Therefore loss is a relative term.

Determine the reference point of loss for a client. The risk of loss means different to different people and will also be different in different situations.

 

Frequency of checking Investments:

How much have I made in the last one month?  What is the absolute return. What is the ratio of loss to gain; are, what some nervous investors seem to have all the time for!

We all know that good advisors recommend investment options, commensurate with the risk profile, time horizon and objective of the goal.

What is the benefit of checking every month, if the goal is fifteen years away?

Advisors, must teach investors to take a long term view.

 

Many investors talk long term and act short term.

Goal Reviews should focus on the goals of the client and the progress made rather than the last quarter performance of the clients investment portfolio.

If the investor changes the goal frequently or requests for portfolio changes based on market information frequently, the advisor must point out the consequences of such actions and his  disagreement on the same, in writing.

 

Living with the Consequence of Decisions:

Investment Decisions are bound by emotional and financial consequences. Regret and hindsight make advisors the black sheep.

An Advisor should clearly emphasise on the long term well being of the investor, understand the emotional biases of the client and specify the objective factors of investing.

If there are extreme cases of disagreement between advisor and client, its best to end the relationship.