Understanding Investor Psychology

Investors don’t understand the true worth of their advisors – which leaves the advisors scratching their heads. They keep wondering – Where have I gone wrong? Is it related to Investor Behavior?

It is not that as an advisor one may actually be wrong, but there are entrenched thought patterns of clients which make them think that way.  The client may not be conscious of this but would be doing it intuitively.

We need to understand first where the biases are coming from & what some of those biases are.  Only when they understand that, can it be tackled.

Hindsight BiasInvestor Behavior

Most of us are not prescient… we are not expected to be. Hence we would not be able to anticipate which events will happen or how it will unfold.  But after the event, it all seems so logical and even cogently explainable.  This is irrespective of how improbable they thought the event was, before it occurred.  That is why people tend to have the opinion that the event could have been predicted – especially by their advisor!

Psychological experiments prove this.  Baruch Fischhoff demonstrated this “I knew this all along” effect, through an experiment. Fischhoff conducted a survey on possible outcomes of Richard Nixon’s trip to Russia & China in 1972 and asked people to assign probabilities to various events, before the trip. When the trip was done & he went back to the same people, there were surprises in store.

Whichever event had actually occurred, people exaggerated the probability they had assigned to that event. If it did not happen, people said they always felt it would not happen ( though the probability they assigned before that even was higher )! After the event, everything seems so logical & plausible, that we automatically adjust our memory to align with what is now known!

Hindsight bias has huge implications for decision makers.  For instance, if during a routine surgical intervention an unpredictable accident caused the death of the patient, it will most probably be believed that the doctor did not assess the situation properly & went in for a risky procedure! The benefit of hindsight & knowing the outcome alters how people perceive what the doctor had done!

That leads us to another bias called outcome bias. This is equally true for Financial Advisors.

Outcome bias

Blaming someone for a good decision which worked out badly &iving too little credit for good moves that with hindsight look all too obvious, is outcome bias in action. When outcomes are bad, people would blame the decision makers for not seeing the writing on the wall, inspite of prudent decisions that the person might have made with the information available at the time of the decision.

This again is proved in psychological experiments.  In case of 9/11 type incidents, the officials concerned seem negligent, even absolutely irresponsible after the event. CIA had intelligence inputs to indicate that Al Qaeda was planning a major attack which went to the National Security Adviser.  This was not escalated to the President, which was questioned after the event. It did not go to the President as it was one of the many intelligence inputs that CIA got and this one did not look specifically significant.

Predicting outcomes is extremely difficult as there are so many variable affecting an outcome.

Action bias

Investor BehaviorThere is another important area where the clients are prone to judge the advisors, rather incorrectly.  Advisors are expected to keep shuffling portfolios or keep doing something, in their quest to advice clients. That is why advisors who tell their clients to just stay invested or tell the clients that no changes are needed in their portfolios, are not that popular. People like action. Those that are constantly seen to be taking action are seen as dynamic & proactive. This is called the action bias.

The good advisors who advised clients against unwanted churn are not fully recognised for their wisdom, even if they have got good returns. The client thinks that the markets have done so well that the returns they have got would anyway have come – an outcome bias acting against the advisor.

Action bias is seen even in sports. In a penalty kick, there is a penchant for the goalie to jump to the left or right without knowing the intention of the kicker. Had the goalie been standing in the middle, he would have probably saved more goals. That’s what studies suggest!  The goalie does not want to be seen as slothful & the viewers equally expect him to dive to the left or right, instead of planting himself in the middle. That is the classic action bias at work!

All these biases and many others are fairly well entrenched and people cannot help it.  For that reason, financial advisors should expect clients to react in a certain way, in specific situations. This by itself is a useful insight.  Knowing this, they should sensitise their clients about such biases & refocus their value proposition to the client.

It is best to own up to the clients that prediction of markets, economy’s direction, how well the equities will perform over the next few quarters, where the inflation would be a year from now etc., are questions which cannot really be answered.  For one, it is impossible to predict such things & get it right. There are just too many variables which can impact events, today. When one gets it right, it is probably not predictive powers; probably it’s just lady luck smiling benignly !

Clients need someone to anchor them & provide the moorings on finances. They want someone trusted, someone dependable whom they can bank upon… who would provide unwavering support & offer appropriate advice at crucial times in their lives, as per their life situation.  Once the clients perceive the  value of their advisors beyond returns, most of these biases would not impact the advisors.

Advisors first have to understand that they cannot predict the future & their value is in being a trusted confidante to their clients. Many advisors themselves still believe that their powers to predict the future is the way they add value.  Now, advisors should know better & reposition themselves and the value proposition that they deliver – which would be good for them & their clients.