How Professional Biases Can Cloud Your Judgment
Financial Advisors have to be aware of their own biases in order to guide clients effectively.
by Justin A. Reckers and Robert A. Simon
Originally published by MorningstarAdvisor.com on July 21st 2011.
The day-to-day operations of an investment advisor, financial planner, or wealth manager are complicated by incessant and unrelenting information overload, constant trials of our competency, and powerful tests of will. You are tasked with the management of other people’s financial matters. You are asked to earn competitive returns and never book losses. You are required to insure your advice is suitable for your clients and in their best interests.
In your discharge of these tasks and obligations, you have developed opinions over time–some rooted in education, others in experience. So what happens when your professional guidance becomes the barrier to economically rational financial decision-making for your clients? You are not a crook or out to do damage. You live by the Hippocratic Oath to do no harm. You read all of the research you can get your hands on. You watch CNBC and Bloomberg to make sure nothing gets past you. You maintain a fiduciary standard for all of your clients and keep up on your continuing education. So how could you be leading your clients into economically irrational financial decisions? Your professional biases can be the most powerful of all.
In previous articles, we have stressed the importance of self determination, informed consent, and a fiduciary standard of care in the professional financial advisory world. As architects of decision-making, these should be your main goals, but you also have to be aware of your own biases in order to guide your clients effectively to this end.
Professional biases come in all shapes and sizes. Just as clients exhibit aversion to loss, so do their advisors. It is incumbent upon the professional investment advisor to understand this and build a disciplined process for constantly monitoring and analyzing the performance of client assets without attaching emotional value to market performance. One of the most important roles of a professional investment advisor is to remove emotion from investment decisions. Some clients are completely unable to do so. Investment advisors have it as their job description.
You all know how much easier it is to deal with your aversion to loss in bull markets, but what happens in bear markets when your clients have lost money? Everyone lost money in 2008 and 2009. We have heard many advisors comment about how much more difficult their job had been during the Great Recession. Their will was tested, their investment discipline either hardened or destabilized, and in many cases client loyalty has come to the forefront.
Whether you are a buy-and-hold manager or an active one, your client review meetings have probably included many questions such as: Where is the bottom? When will we get out? In the buy-and-hold world, your answer is probably dictated only by change of time horizon because your discipline tells you to always be invested. Your job in the review meetings is to be the voice of economic rationality and deter your clients from making emotional decisions. But what if you also have an aversion to loss? Do you find yourself questioning your investment discipline? It was hard to watch the S&P 500 lose 56% in 2008 and 2009. Even the most hardened buy-and-hold advocates were tested.
We suggest using investment policy statements to clearly delineate downside risk tolerance and processes for evaluating the performance of investments. Writing it down commits your discipline to contract and removes much of the emotional connection. We suggest having checks and balances in place through an investment policy committee or board of advisors. Even the strongest willed advisors can be affected by temporary economic irrationality if left alone. Maybe even join a practice group through your local financial planning association.
Confirmation bias is another common professional bias for financial advisors. Confirmation bias is the tendency for advisors to seek and rely upon information that confirms their preconceived notions regardless of whether it is true. This bias is particularly strong in situations where advisors have attached significant value to large issues and established beliefs. Advisors can end up anchoring upon their established beliefs and refuse to receive or test the possibility that other options even exist.
Buy-and-hold investing may be a perfect example of confirmation bias. Many advisors were converted to buy-and-hold managers in the ’90s when the concept was popularized, index funds proliferated, and the rising tide of our 1982-2000 bull market lifted all ships. It is not our intention to support one investment management discipline over another, just to point out places where we see biased behavior. The choice of buy-and-hold discipline is not biased in and of itself. It is the devout belief system that often comes with this discipline that can cause problems. Many advisors will choose this discipline after seeing a demonstration that shows the S&P 500 returning 10% per year from 1906 to 2011. The data would be correct, but they will pay no attention to the complicating factors that must be incorporated if they are to be making economically rational decisions with all available information.
This is also known as availability bias, where the advisor is relying upon available information only. Similarly, your client may tell you that his parents lived only to age 70 so they will not live past that age, and it would be a waste to plan for it. Or maybe his father lived to age 90 smoking two packs of cigarettes a day so there is no reason for him to quit smoking. Both of these statements are beliefs created from the available experience of the client. This information will be the most easily recalled or available and may ultimately be relied upon. In the instance where an advisor’s belief system allows only for buy and hold, this is what will be recalled and relied upon.
What about the individual client time horizon? You certainly haven’t made 10% per year since 2000. What about price-to-earnings ratios? Ten-year trailing P/E ratios remain very expensive. What about global debt and banking crises? Everyone is waiting for the next shoe to drop.
The point is to remember that there is never a silver bullet in the world of investment advisory and financial planning. If there were, someone would have figured it out by now. If you make decisions and help your clients make decisions without all available information, these decisions may be based 100% on your own beliefs and biases. A decision-making process based solely upon your belief system is not an accurate and complete analysis, and could lead your clients down the road to economic irrationality.
We will continue our Applied Behavioral Finance series next month with a look at inertia in financial decision-making, and how to affect positive change when your client is disinterested or apathetic. We will follow with an analysis of what we call the Blue Screen of Death in financial decision-making to close out the summer in September.
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.