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! 3
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? 4
Behavioural biases and individuals • Framing • Anchoring • Representativeness • Availability bias • Confirmation bias • Myopic loss aversion • Self-control • Regret aversion • Herding • Overconfidence • Prospect theory 5
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! 6
Gender, education and experience Gender Education 60 50 40 30 20 10 0 High school, diploma and Undergraduate Masters degres PhD vocational degree Male Female Average accounting experience: 24 years Minimum: 1 year. Maximum: 60 years 7
Financial knowledge Correct replies to a three- question financial knowledge snapshot Self-reported understanding of finance 70 60 60 50 50 40 40 30 30 20 20 10 10 0 0 0 1 2 3 Correlation between the two = 0.2 8
What percentage of IPA members provide financial advice? 15% of our respondents (22 out of 149) provide financial advice and planning for individuals What is seen as a barrier to access financial planning? 120 100 80 60 40 20 0 Lack of Lack of High costs Lack of Low Lack of trust in trust in knowledge importance access to financial financial planners planning services overall 9
Which side of this table sounds more like you? IN THEORY IN PRACTICE You’re not sure what your goals are. Last time You have clear and consistent financial goals. you thought you knew, you had to change them. That stock your cousin recommended was “a You carefully calculate the odds of success and sure thing” – until it stunned you both by going to failure. zero. You know exactly how much risk you’re When the market was going up, you said you comfortable taking. had a high tolerance for risk. When it went down, you became intolerant in a hurry. You efficiently process all the available You owned stock in Enron and World-Com, but information to maximise your future wealth. 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 In 1720, Sir Isaac Newton was wiped out in a make stock-market crash, blazing a trail of financial failure that geniuses have been following ever since. The more closely you follow your investments, People who keep up with the news about their the more money you’ll make. stocks earn lower returns than those who pay almost no attention. “Professional” investors, on average, do not The more work you put into investing, the more money you’ll make. outperform “amateurs”. Source: Jason Zweig: Your Money and Your Brain, Simon and Schuster, 2007. 10
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. 11
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 13
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 14
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” 16
Financial advisors should…. Don’t just prove it; try to disprove it Ask another question When asked ‘will this stock keep going up?’ The reflexive brain believes the best way to many investors consult a chart of recent prove something is to keep looking for more performance. If the trend line slopes proof that it is true. This is confirmation bias. upwards they immediately say ‘yes’. Of Eg. When researching an investment, someone course all the trend line shows is that the might inadvertently look for information that stock has gone up and they’ve answered an supports his or her beliefs about the investment entirely different question. This is an and fail to see information that presents different example of representativeness. ideas. As a financial advisor ask a follow up query. Eg “how do I know?”, “what is the As a financial advisor you should be playing the evidence?” or “Do I need more ‘devil’s advocate’. Get more information and try information ?”, “what would I do with this to help the client form an unbiased conclusion. person’s money?” 17
Financial advisors should…. Conquer your senses with Only fools invest without rules common sense As a financial advisor it’s your responsibility to use the reflective part of your brain when Sights and sounds engage your reflexive advising. system; words and numbers activate your reflective system Examples: investigate then invest; don’t put more than 10 percent of your portfolio in one asset – People are inherently excited by motion even if you’ve been told it’s a total winner; know You should never passively accept what you don’t know; the past does not predict information in its original packaging. the future; if it sounds too good to be true, it probably is; costs are killers; don’t put all your Make sure you unpack it in several ways. eggs in one basket. It could be the way it has been framed to Be aware that client behavioural biases, eg appeal to consumers. 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. 18
Financial advisors should…. Be aware of bounded rationality Be aware of overconfidence It’s the idea that our decision making is Advisors may believe they can affect events influenced by constraints on information, more than they actually can (overconfidence), or cognitive ability and time. that they are more likely to succeed or less likely to fail than another individual (overoptimism) 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. 19
Financial advisors should…. Be aware of framing Be aware of herding As advisors, we encounter people on an Advisors must control emotions, do due diligence and curb clients’ emotions and tendency to herd. emotional roller-coaster as it pertains to achieving financial security. Advisors need to be aware of ‘group - think’. 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. 20
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