We make decisions in different ways – but most are driven by our natural biases. These biases can affect an Advisor’s ability to recommend the appropriate options for clients, setting them up for a potential compliance issue. Natural Behavioral Biases also can affect the client’s ability to understand and make rational decisions.
Psychologists Daniel Kahneman, Paul Slovic, and Amos Tversky introduced the concept of psychological bias in the early 70s and published their findings in the 1982 book, Judgement under Uncertainty.They explained that psychological bias is the tendency to make decisions or take action in an illogical way. For example, you might subconsciously make selective use of data and fail to apply common sense to a measured judgment. This is how people make mistakes or accidents happen, right?
Furthermore, Since its inception nearly three decades ago, behavioral economics has upset the pristine premise of classical economic theory – the view that individuals will always behave rationally to achieve the best possible outcome. Today it’s clear that the vagaries of individual and group psychology can cause irrational decision making by both individuals and organizations, resulting in less than ideal outcomes. Even the best-designed strategic-planning processes don’t always lead to optimal decisions.
If decisions on a certain course of action rests with individuals, and bias plays a significant role in human decision-making, then how can any investor (or their advisor) make rational investment decisions?
Improving financial decision-making requires limiting both investor’s and advisor’s own biases. In the advisor/investor relationship this is a difficult path to navigate because bias is hard-wired in our nature. It goes beyond simplistic Compliance rules & regulations, or a Risk Tolerance matrix. We’re talking about applying validated psychological assessment data to the landscape of financial decision-making. These are the same tools and insights that businesses and military groups employ in order to ID best fit for a role on a tem or determine predictable outcomes based on a given set of circumstances and the individuals involved.
Many of the behavioral economists over the years have presented sound academic papers on behavioral bias, but few have presented answers to this dilemma. However, one such answer could be for both advisor and investor to complete a robust and validated Natural Behavior Discovery process, a personality assessment. The 5 benefits outlined below are:
- Highlight areas of bias in both parties
Part of knowing one’s behavior beyond what’s presented on the surface (Learned Behavior) is understanding our internal quirks. These are the potential pitfalls, or holes, in our irrational decision-making process. By acknowledging them and mitigating their effects, natural bias can be effectively managed.
- Identify risk tolerance
Part of the basis of any successful financial planning is knowing the limits of a client’s exposure to market volatility vs. their goals for accumulating and managing wealth. As it’s part of a person’s personality, a discovery process platform will uncover their natural risk propensity and risk tolerance, so a financial advisor can plan accordingly.
- Minimize compliance issues
There are two (2) ways to avoid compliance issues, beyond following the letter of the rules and regulations placed upon advisors. First, ensure a clients goals are accurately identified. With a definitive path laid out in order to attain them, simple hints and reminders will help guide the client to stay true to their own plan in the face of market volatility or life changes. And second, matching personality types between client and advisor. Having similar communication styles and/or ways of thinking about finances, risk and decision-making will minimize the risk of mis-communication and misunderstanding. A proper assessment of all parties helps to ensure the closest match.
- Improve communication
Much like matching personalities, everyone has a certain communication style in how they best engage others. Some may need more upfront information, and then time to reflect and absorb or reach for themselves, while others just need a quick run-down of the bullet-points. Adapting to an individuals style helps keep every engagement successful and personal. Most compliance issues arise from poor communication.Assessing the styles of all involved helps close the gap.
- Deepen client relationships overall
The combination of the points detailed above provides a holistic method to successfully engage each client on a personal level, deepening that relationship while mitigating gaps in personality and communication. As the financial services sector becomes more familiar with behavioral economics and the role it plays in terms of strategic thinking in firms and with regulators, it is now expected that the financial advisory industry as a whole will take biases and irrational behavior into account in the product design and marketing process, as well as in their overall strategic planning. The opportunity is to now apply these psychological tools and insights to financial relationships and decisions, to achieve a specific goal with the investor’s best interest in mind.