Neuroscience Supports a Fiduciary Standard for Financial Advisors

Because clients are predisposed to ‘offload’ important financial decisions, a mandatory fiduciary standard of care should be applied to any individuals who purport to provide financial advice.

by Justin A. Reckers and Robert A. Simon

Originally published by MorningstarAdvisor.com on May 19th 2011

The first article in this behavioral finance-focused series was titled “Financial Advisors as Architects of Decision Making” and included the following message:

“Effective and rewarding client relationships require the comfort of factual data, trust in the expert, and a personal relationship re-enforced by the advisor’s ability to recognize and address the cognitive and emotional barriers a client faces in decision making.”

We have now written 12 articles on the topic and want to go back to the roots of our motivation and the concepts we rely upon to form our commitment to the work.

We believe there are two important goals that should remain at the forefront of advisors’ minds in all advisory relationships. These two goals are the basis for our belief that financial advisors should become architects of financial decision-making and that a fiduciary standard of care should be mandatory when providing financial advice. They are the motivation for all of our work in the world of behavioral finance. The first is to encourage self-determination. The second is to facilitate informed consent.

Too often advisors become expert wielders of advice and commentary like talking heads on CNBC, product pushers, and newsletter salespeople. They lose the human connection that is necessary to truly reflect each client’s individual financial reality. If you miss each individual’s beliefs, values, fears, biases, and tendencies, you will miss the connection. If you miss the connection, you will fail to facilitate a decision-making process, and you will be nothing but a salesperson pushing your own agenda conflicted by your own confirmatory bias.

The real value in financial advisory practice is helping each individual client make the best financial decisions for his or her family, circumstances, and goals by encouraging self-determination and informed consent. These two tenants form the architecture of “rational” decision-making.

Self-Determination
Self-determination at its simplest is the power or ability to make a decision for oneself without influence from outside forces. Self Determination Theory is concerned with human motivation related to our innate psychological needs and studies the motivation behind choices people make away from external influence and interference. In order to truly encourage ownership of financial decisions, advisors must learn to encourage self-determination. This means moderating or removing the external forces that influence the client.

Neuroscience has shown that receiving expert financial advice can neurobiologically “offload” the responsibility for financial decision-making in circumstances complicated by the presence of risk. As described in 2009 study titled, “Expert Financial Advice Neurobiologically ‘Offloads’ Financial Decision-Making Under Risk,” a group of economists and psychiatrists used magnetic resonance imaging (MRI) to investigate the neurobiological processes associated with making financial decisions in risky circumstances with and without expert advice. The results of the study showed that expert financial advice significantly swayed results in the direction suggested by the expert advice. Effectively your client is offloading the responsibility for making financial decisions to you because they believe relying upon the external force will help reduce the perceived risk in the decision-making process. This is a clear departure from the concept of self-determination and leaves clients with decisions made by an unrelated party. In the absence of self-determination and informed consent, clients will never choose what is best for their family because they will not be the ones making the decision. You will.

Risk is inherent in the financial decision-making of all parties: the risk that goals will not be met, that premature death will negatively affect one’s family, that the stock market will crash, that disability will damage earning capacity, that a municipality will default on its debt, that an economic recovery will falter, that a job will be lost, or that a business will fail. Every client has risk involved in every financial decision they make.

If risk is present in all financial decisions, then clients run the risk of giving up the responsibility for their financial decision-making for the good of their family’s financial future or for the good of their business partners to someone in the financial-services industry. Many times in the world of financial advice, this unrelated party is a salesperson and has no mandatory fiduciary duty to the client. They must only prove that what they sold their client was suitable at the time of the transaction, not that they had the client’s best interests in mind or that they, if given the choice and same circumstances, would make the same decision for their own family.

Informed Consent
So what happens if the client throws his hands up and says, “I don’t know what I am doing; isn’t it your job to tell me what I should do?” We fully recognize that self-determination is not always possible. Aside from circumstances where parties lack the mental faculties to be an active participant in decision-making, we still have the obligation to seek informed consent.

In situations where it is decided to rely upon the advice of an investment manager and grant that person discretionary authority to manage investments, it should be absolutely mandatory to have a written and signed contract or Investment Policy Statement delineating the client’s informed consent to a risk tolerance level, detailing the client’s objectives and the responsibilities of each party to the contract. These types of engagement agreements, investment policy statements, and other contracts have been in use within the independent financial advisor community for many years, but are not mandatory unless advisors have taken the extra steps to become a Certified Financial Planner practitioner, Accredited Investment Fiduciary, or other accreditation demonstrating commitment to fiduciary duty.

We believe the value of self-determination and the neuroscientific evidence proving the offloading of financial decision-making under risk are the two most important arguments for a mandatory fiduciary standard of care to be applied to individuals of all types who purport to provide financial advice.

If we are to move successfully toward a required fiduciary standard of care as contemplated in recent legislation, it may require a move away from economic analysis to prove or disprove the efficacy and importance of the standard. Instead we might concentrate on a more serious look at the psychology behind financial decision-making, the value of self-determination, and the risk of Americans neurobiologically offloading the responsibility for financial decisions to a salesperson who may not have their best interests in mind.

We will continue our applied behavioral finance series next month with a look at the concept of Libertarian Paternalism as coined by Richard Thaler and Cass Sunstein and how it interacts with self-determination, and then we will begin a short foray into common professional biases such as confirmatory bias, attribution error, and availability.

Citation: Engelmann JB, Capra CM, Noussair C, Berns GS, 2009 Expert Financial Advice Neurobiologically “Offloads” Financial Decision-Making under Risk. PLoS ONE 4(3): e4957. doi:10.1371/journal.pone.0004957

Justin A. Reckers, CFP, CDFA, AIF is Director of Financial Planning at Pacific Wealth Management  www.pacwealth.com and Managing Director of Pacific Divorce Management, LLC www.pacdivorce.com, in San Diego.

Robert A. Simon, Ph.D. www.dr-simon.com is a forensic psychologist, trial consultant, expert witness, and alternative dispute resolution specialist based in Del Mar, Calif.