Improve your practice by challenging your biases

Have you ever had a client who insisted on holding a losing investment…or buying into the tail end of a frenzy…
October 2019

Chris Kerlow

CFA, Portfolio Manager, Richardson GMP Asset Management

LEARN MORE ABOUT THE AUTHOR
Subscribe to our Insights

Risk Disclaimer

The information, opinions, estimates or forecasts contained in this article were obtained from sources reasonably believed to be reliable and are subject to change at any time. It has been produced for information only. Views and opinions should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned. No action must be taken or refrained from being taken based on this content alone.

Key takeaways:

  • Understanding behavioural biases that cause sub-optimal decision making helps you and your clients
  • How applying behavioural finance, such as Prospect Theory/Loss Aversion and the Endowment effect, can be highly practical for your business
  • Adoption of behavioural finance techniques will give you a competitive advantage

Have you ever had a client who insisted on holding a losing investment…or buying into the tail end of a frenzy for fear of missing out? Have you yourself made a decision with complete confidence only to have it turn out poorly? According to Richardson GMP Portfolio Manager Christopher Kerlow, by applying behavioural economics to his investment management process, he’s become better able to mitigate the cognitive and emotional biases that lead to rash thinking, is more analytical and – ultimately – provides even greater value to the clients in his business.

Becoming a mainstream discipline

Once the domain of a small number of economists and psychologists, behavioural economics is no longer a marginal discipline. There is a growing list of real-world applications: governments, marketers, media firms, and others have teams of experts applying research in practical ways to guide policy, sell products, or encourage consumers to click a link.

The study of how we make decisions has been somewhat slow to come to wealth management. In part, it may be because our industry is firmly grounded in the idea that markets work and are designed to harness the wisdom of crowds. While that’s true over a long enough horizon, those of us who monitor markets daily know that they’re not always efficient. And even when they work as intended – with assets eventually finding their fair value – there will always be costly investor errors along the way.

The costs of these cognitive and emotional biases are measurable and likely greater than one might think. According to DALBAR’s 2018 Quantitative Analysis of Investor Behavior, the average annualised return of the S&P 500 composite over the last 20 years was 7.2%, but the average equity investor earned just 5.29%. The main cause for this huge discrepancy is behaviour – a sobering fact I share with my clients. It’s often a fear or greed play – selling on lows and buying on highs. And it’s exactly why advisers are able to add value; we help clients to stay invested in tough times, or add capital during drawdowns, versus taking money off the table at the worst possible time.

Understanding the causes of sub-optimal decision making gives us an advantage. That’s in part because behavioural finance offers insights that show how people act irrationally in predictable and quantifiable ways – helping us to develop more considered and strategic investment strategies.

 

Become a better adviser by recognising irrationality

As wealth professionals, we tend to have very strong confidence in our abilities. Over time, that self-confidence becomes reinforced because, more often than not, our intuitions tend to be correct. However, if you’ve been managing money long enough, you know that you’re not always right; even the best-of-the-best are only correct 60-65% of the time from a relative basis standpoint.

To guard against “overconfidence bias” – the belief that one’s own abilities are greater than their actual abilities – my team started doing more and more work on behavioural economics and finance, making it a point to look for, challenge, and minimise biases in our own decision-making. Our process is to acknowledge that our views could be wrong and to take actionable steps, such as asking colleagues to poke holes in our analyses. Instead of spending all of our time looking for the next best idea, we have a greater focus on the potentially negative scenarios that could impact our current investments. This helps to ensure that we don’t miss a foreseeable pitfall because we’re blinded by overconfidence.

Risk Disclaimer

The information, opinions, estimates or forecasts contained in this article were obtained from sources reasonably believed to be reliable and are subject to change at any time. It has been produced for information only. Views and opinions should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned. No action must be taken or refrained from being taken based on this content alone.

We’re able to steer clients away from rash, emotional decisions, allowing them to realise the true value of impartial and considered advice.

Knowledge of human psychology is a useful tool as we’re able to steer clients away from rash, emotional decisions, allowing them to realise the true value of impartial and considered advice. While telling a client that they may be on the wrong path takes finesse, we see it as part of fiduciary duty, and overall the approach – and the results – are appreciated. In fact, client feedback has been so positive that we started a series of educational events in which we demonstrate a variety of different biases – incorporating market-simulation activities and games which trigger emotion and allow clients to make real-world errors.  I’d  estimate that over the past year, roughly half of our weekly market commentaries have centred around behavioural finance or related strategies.

 

Behavioural finance 101: highly practical for your business

In addition to overconfidence, there are many other prevalent biases and cognitive errors that have been identified and researched over the years. The Behavioral Economics Guide 2018 identifies roughly 100. Some of these insights may seem like common sense, while others are surprisingly counterintuitive. Overall, I’ve found that being aware of them adds an aspect to finance that is humanising, fascinating and highly practical for our business. For example:

  • Prospect Theory/Loss Aversion: For advisers, this is the most widely recognised thesis developed by Nobel Prize-winners Daniel Kahneman and Amos Tversky. This theory describes how people choose between options – and why they often make choices that can be self-damaging. In particular, when choosing among several alternatives, people avoid potential losses and optimise for sure wins because the psychological pain of losing is immensely greater than the pleasure of an equivalent gain. In practical terms – it’s the reason that people tend to hold onto losing investments for too long or sell winners too early.
  • Endowment Effect: We all tend to overvalue the things we already own – investments included. The feeling is particularly strong when there’s an emotional attachment to an asset. For example, a client recently came to us with large blocks of shares that were bequeathed by her late father. While these were high-quality, blue-chip companies that I might recommend for a portfolio on an individual basis, having so much wealth concentrated into two holdings presented too high a level of risk. It was a challenging discussion, given their long-term performance, so I couldn’t debias her with maths, or point to an uneven manager track record. However, as she’d entrusted her adviser to ensure her retirement savings were protected, it was our obligation to steer her toward a more diversified solution. By explaining the endowment effect, we are able to help clients move past emotional attachments and rationally view assets as the financial instruments that they are.

It’s becoming increasingly mainstream, and, I’d suggest, should be mandatory knowledge in our industry.

Gain a competitive advantage – now

While we were relatively early adopters of the discipline into our practice, behavioural finance is no longer a niche or simply an area of study. It’s becoming increasingly mainstream, and, I’d suggest, should be mandatory knowledge in our industry, particularly for advisers who want to maintain a competitive advantage.

I believe that an understanding of human decision-making processes will become increasingly valuable as technology further commoditises market data. Right now, my Bloomberg terminal gives me a slight edge, but I know that my summer intern had access to most of that information on Yahoo or Google Finance almost as quickly – and that means that clients do too. While that professional money manager data edge may be fading, one thing we can count on in the future is the natural emotional responses our clients will feel when they see the market, or their own holdings, fluctuate – or when they see the allure of a trend. During the bitcoin rally, my own grandfather came to me asking if he should buy, even though he had no idea what bitcoin was…just that it had gone up dramatically.

More to the point, as the field gains greater traction, your competitors will become increasingly aware that a real differentiator will be having the skills necessary to engage in hard, considered client conversations about emotional attachments and biases – and to ultimately help influence better results through an understanding of behavioural science.

Richardson GMP Disclosure:

This material is provided for general information and is not to be construed as an offer or solicitation for the sale or purchase of securities mentioned herein. Past performance may not be repeated. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please seek individual financial advice based on your personal circumstances. However, neither the author nor Richardson GMP Limited makes any representation or warranty, expressed or implied, in respect thereof, or takes any responsibility for any errors or omissions which may be contained herein or accepts any liability whatsoever for any loss arising from any use or reliance on this report or its contents. Richardson GMP Limited is a member of Canadian Investor Protection Fund.

Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.

Related articles