How Do Behavioural Biases Affect Financial Advisors? Christine - - PowerPoint PPT Presentation

How Do Behavioural Biases Affect Financial Advisors?

Christine Brown Professor Department of Banking and Finance Monash University

Why does it matter?

• It’s absolutely critical to set and manage

client’s expectation throughout the financial planning process

• The way we’re wired emotionally and the way

we need to invest for the long haul doesn’t mix well

• For example we shop for bargains but we

don’t invest when the stock market goes down – we tend to sell!

• The financial planner’s role is to curb clients’

most dangerous behavioural biases and prevent them from making costly mistakes

• But the financial planner also needs to be

aware of their own biases!

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Plan

How do behavioural biases affect individuals? The survey A snapshot of the IPA membership Workshop exercises How can financial planners help overcome behavioural biases in clients?

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Behavioural biases and individuals

• Framing
• Anchoring
• Representativeness
• Availability bias
• Confirmation bias
• Myopic loss aversion
• Self-control
• Regret aversion
• Herding
• Overconfidence
• Prospect theory

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IPA survey conducted by A/Prof Yulia Veld-Merkoulova and Prof Christine Brown

• The purpose of our study is to investigate whether common risk attitudes and behavioural biases

have an impact on decision-making of professional accountants.

• We have 149 responses from the IPA membership – we’d like more!

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Average accounting experience: 24 years Minimum: 1 year. Maximum: 60 years

Gender

Male Female 10 20 30 40 50 60 High school, diploma and vocational Undergraduate degree Masters degres PhD

Education

Gender, education and experience

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Correlation between the two = 0.2

10 20 30 40 50 60

Self-reported understanding of finance

10 20 30 40 50 60 70 1 2 3

Correct replies to a three- question financial knowledge snapshot

Financial knowledge

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What percentage of IPA members provide financial advice?

15% of our respondents (22 out of 149) provide financial advice and planning for individuals

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20 40 60 80 100 120 Lack of trust in financial planning Lack of trust in financial services

• verall

High costs Lack of knowledge Low importance Lack of access to planners

What is seen as a barrier to access financial planning?

Which side of this table sounds more like you?

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Source: Jason Zweig: Your Money and Your Brain, Simon and Schuster, 2007.

IN THEORY IN PRACTICE

You have clear and consistent financial goals. You’re not sure what your goals are. Last time you thought you knew, you had to change them. You carefully calculate the odds of success and failure. That stock your cousin recommended was “a sure thing” – until it stunned you both by going to zero. You know exactly how much risk you’re comfortable taking. When the market was going up, you said you had a high tolerance for risk. When it went down, you became intolerant in a hurry. You efficiently process all the available information to maximise your future wealth. You owned stock in Enron and World-Com, but you never read the fine print in their financial statements – missing the signs of trouble to come. The smarter you are, the more money you’ll make In 1720, Sir Isaac Newton was wiped out in a stock-market crash, blazing a trail of financial failure that geniuses have been following ever since. The more closely you follow your investments, the more money you’ll make. People who keep up with the news about their stocks earn lower returns than those who pay almost no attention. The more work you put into investing, the more money you’ll make. “Professional” investors, on average, do not

• utperform “amateurs”.

Workshop 1: Evidence for irrational behaviour

1. You have $1,000 and you must pick one of the following choices: Choice A: You have a 50% chance of gaining $1,000, and a 50% chance of gaining $0. Choice B: You have a 100% chance of gaining $500. 2. You have $2,000 and you must pick one of the following choices: Choice A: You have a 50% chance of losing $1,000, and 50% of losing $0. Choice B: You have a 100% chance of losing $500.

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Prospect theory

The function represents the difference in the amount of utility to be achieved by a certain amount of gains or losses. The most evident feature is how a loss creates a greater feeling of pain compared to the joy created by an equivalent gain. For example, the absolute joy felt in finding $50 is a lot less than the absolute pain caused by losing $50.

Humans are “pattern seeking primates”

Our brains are wired to deal with money in a bad way The financial markets are super complex – we created them Ninety-five percent of what happens in finance is random noise, yet investors constantly convince themselves that they see patterns in market activity

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Workshop 2: Coin tossing experiment

• Two people in the room (you choose) will be special.
• Each person in the room (except the special people) is to toss a coin 30 times registering the

sequence of heads and tails eg HTHT…..

• The two special people will each simulate the coin tosses by just writing the random sequence of

heads and tails

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How could I have been such an idiot?

Why are we so bad with money?

The neural activity of someone whose investments are making money is indistinguishable from someone who is high on cocaine or morphine Our brains are wired to deal with money in a bad way After two repetitions of a stimulus – say a stock goes up twice in a row – the human brain automatically, unconsciously and uncontrollably expects a third repetition Once people conclude that that an investment’s returns are “predictable”, their brains respond with alarm if that apparent pattern is broken Anticipating a gain, and actually receiving it, are expressed in entirely different ways in the brain, helping to explain why “money does not buy happiness”

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Financial advisors should….

Ask another question

When asked ‘will this stock keep going up?’ many investors consult a chart of recent

• performance. If the trend line slopes

upwards they immediately say ‘yes’. Of course all the trend line shows is that the stock has gone up and they’ve answered an entirely different question. This is an example of representativeness. As a financial advisor ask a follow up query. Eg “how do I know?”, “what is the evidence?” or “Do I need more information?”, “what would I do with this person’s money?”

Don’t just prove it; try to disprove it

The reflexive brain believes the best way to prove something is to keep looking for more proof that it is true. This is confirmation bias.

• Eg. When researching an investment, someone

might inadvertently look for information that supports his or her beliefs about the investment and fail to see information that presents different ideas. As a financial advisor you should be playing the ‘devil’s advocate’. Get more information and try to help the client form an unbiased conclusion.

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Financial advisors should….

Conquer your senses with common sense

Sights and sounds engage your reflexive system; words and numbers activate your reflective system People are inherently excited by motion You should never passively accept information in its original packaging. Make sure you unpack it in several ways. It could be the way it has been framed to appeal to consumers.

Only fools invest without rules

As a financial advisor it’s your responsibility to use the reflective part of your brain when advising. Examples: investigate then invest; don’t put more than 10 percent of your portfolio in one asset – even if you’ve been told it’s a total winner; know what you don’t know; the past does not predict the future; if it sounds too good to be true, it probably is; costs are killers; don’t put all your eggs in one basket. Be aware that client behavioural biases, eg herding, may prompt or reinforce your own bias. As the advisor you need to be aware of the likely biases that will affect client decisions.

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Financial advisors should….

Be aware of bounded rationality

It’s the idea that our decision making is influenced by constraints on information, cognitive ability and time. In optimal decision making the decision maker is convinced there is no better option. Satisficing decision makers may not have enough information, time or the capacity to make the ‘best’ decision.

Be aware of overconfidence

Advisors may believe they can affect events more than they actually can (overconfidence), or that they are more likely to succeed or less likely to fail than another individual (overoptimism)

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Financial advisors should….

Be aware of framing

As advisors, we encounter people on an emotional roller-coaster as it pertains to achieving financial security. Retirement may be important to all clients, but its importance increases with age. Insurance is rarely at the top of client lists, but when faced with own mortality or that of a loved one, a shift in importance occurs. Since no two clients are alike, it is critical that we as advisors hone our skills at presenting relevant information in different ways because we know that something said will be received differently by different clients.

Be aware of herding

Advisors must control emotions, do due diligence and curb clients’ emotions and tendency to herd. Advisors need to be aware of ‘group-think’.

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CFA survey 2016

When asked financial advisors ranked expenses as the 8th most important factor when analysing a mutual fund (after such things as performance, risk, how old the fund is, how long the current manager has been in charge). What do you think the most important factor is for long-run returns?

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