Investment Advisor Interests  05/01/2023 NAPA RSS Icon

The Behavioral Biases of Financial Advisors

By Jon Talamas

The Behavioral Biases of Financial Advisors

Financial advisors are prone to giving behaviorally biased investment advice. Here’s how to reduce these errors to produce better client results.

Behavioral finance has dramatically enhanced the registered investment advisor (RIA) business over the last few decades. It has helped advisors counsel clients about mental errors that can lead to sub-optimal investment performance.

Today, many advisors commonly use behavioral-finance knowledge to help clients avoid investing calamities. But fewer use this information to improve their decision-making. This article helps bridge this gap, informing you of the significant behavioral biases for advisors . We also share tips for avoiding these errors in your practice.

Basic Terms

The notion that investors are rational is a truism in finance. However, early researchers, such as Daniel Kahneman, Amos Tversky and Richard Thaler, showed that investors often fail to act sensibly to mitigate risk. They often make errors that can lead to punishing losses.

It’s helpful to divide investment advisor biases into cognitive and emotional categories. The former are thinking errors that happen during analytical work. They occur because advisors often rely on mental shortcuts known as heuristics to understand the world better. Because investment advisors have many incoming data streams— from client risk profiles to asset-class performance to geopolitical news— they use heuristics unconsciously to reach decisions without succumbing to information overload.

For example, two common heuristics are confirmation bias— a cognitive error in which advisors ignore data that challenges their preconceived notions— and anchoring— a way in which they rely on earlier information to make decisions even though more current data is available. Sadly, even though such “tricks” save time and mental bandwidth, they can destroy client portfolios quickly.

Emotional biases result from fears, desires or other emotional factors that blind advisors to important data. A common emotional bias is loss aversion, which is the tendency for advisors— and investors— to feel the pain of a loss more acutely than they feel the joy of an equivalent gain. This can lead people to hold onto losing assets longer than they should, producing an even greater loss.

Similarly, status quo bias leads investors to stick with an investment strategy because they fear change, even if the reason for maintaining the approach no longer exists.

Where Advisors Go Wrong

What are the most common financial advisor biases ? According to a 2019 Cerulli Associates survey, they include the following:

  • 82% of advisors said they, “…tend to feel twice as bad about a loss as they feel good about an equivalent gain,” (loss aversion bias).
  • 65% believed their, “…portfolio management skills can help clients outperform the market,” (overconfidence bias).
  • 58% said they tended, “…to rely on information that is readily available or easily recallable,” (availability bias).
  • 54% said they, “…seek information that confirms [their] perceptions or current views,” (confirmation bias).
  • 51% admit being, “…influenced by recent news events or experiences when making investment decisions,” (recency bias).
  • These aren’t the only behavioral errors that confound effective investment management. Advisors often have more confidence in their predictive skills and ability to control events than they actually do. An RIA’s behavioral bias  can lead to a belief in market timing or their ability to perceive meaning in random asset price fluctuations.

Another destructive bias is anchoring, which occurs when advisors believe something because they learned it years ago. For example, advisors used to— and still— cite a study showing a 4% annual withdrawal rate would never exhaust a portfolio, even with market volatility. Subsequent research has revealed that 4% is not a hard and fast rule. Success depends on the market climate when someone retires and the sequence of investment returns early during retirement.

Trend chasing is also quite common in the RIA business. This occurs when advisors see institutional investment strategies based on sophisticated algorithmic models wrack up excellent results for multiple quarters or years. Based on this performance, they decide to recommend these strategies to their clients, even though the underlying market-based logic may no longer apply.

Familiarity bias occurs when advisors stick to the investment strategies they use most frequently. This can be damaging because third-party asset managers offer just about every option. Not fully availing themselves of these choices can impede the construction of well-diversified client portfolios.

Furthermore, investment advisors are prone to herding bias. This occurs when the person sees other advisors flocking to a strategy and decides they want to join the party. The herding impulse is especially powerful during sustained bull markets when asset values achieve repeated highs. The lure of attaining comparable returns can tempt advisors and their clients to abandon their well-designed investment plans to snare greater short-term alpha.

How to Reduce Your Behavioral Biases

Admitting you have behavioral biases is essential. Acknowledge that you are prone to making the same cognitive and behavioral errors your clients do. Then train yourself to prevent them. Here’s how:

  • Review the five common advisor biases discussed earlier– Now think about instances where you made those mistakes. Evaluate your rationale for making the decision, and jot down the flaws in your reasoning or emotional excesses. Finally, write down how you’ll approach similar choices in the future.
  • Consider your loss aversion or overconfidence in making investment decisions– Play devil’s advocate with yourself so you don’t rush to poor decisions based on your fears of loss and excess confidence.
  • Take a long-term view of client portfolios and your career– Keeping your eyes fixed on the goals will keep you emotionally grounded and better able to avoid cognitive errors, such as herding, loss aversion and over overconfidence. It will also prevent you from burning out while chasing investment fads.
  • Implement systematic processes in your workflow– Let workflow procedures define your actions, not errant thoughts and impulses. This will help reduce your behavioral mistakes. For example, taking advantage of automatic portfolio rebalancing can prevent you and your clients from making fearful or impulsive decisions that violate your long-term plans.
  • Always challenge your beliefs– After you reach an investment decision, ask yourself, “What is my evidence for knowing this?” Reality testing your choices is a powerful strategy for avoiding behaviorally biased conclusions.
  • Be a contrarian when it comes to research– Don’t just look for evidence that validates your investment approach. Instead, seek information that disproves your thesis.
  • Beware of the limitations of rationality– In the real world, you will always face constraints on your reasoning ability, available data and time. Instead of forcing the issue, admit that you lack sufficient resources to make a good decision, and shelve it until you’re better equipped to decide.
  • Resist client biases– The pressure to comply can be intense, especially when dealing with demanding clients, but it’s essential to resist it.

Finally, don’t succumb to overconfidence. Many advisors overestimate their ability to affect events or achieve successful outcomes. Train yourself to think with humility about your investment insights and portfolio management skills. Balance your professional expertise with worst-case-scenario analyses to ensure you’re offering your clients the most well-rounded advice.

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