Advisors: Are You Fooled By Your Own Bias?

Pioneering research in the psychology of investing, now known as behavioral finance, by Nobel Peace Prize winners Daniel Khaneman and Amos Tversky, and other leading academics, has highlighted key investment behavior insights. These insights are all a dimension of a person’s financial personality.

Understanding a person’s financial personality, whether advisor or investor, informs the degree to which each is biased in their decision making and the way in which advice could more effectively be delivered.

There is a clear connection between these investment behaviors and natural behavior and identifiable traits. As each person, whether advisor or investor, is different, the extent to which each of these investment behaviors exists in any one person will be different depending on their strongest natural behavioral trait. Usually, each person will clearly exhibit several investment behaviors depending on their natural behavioral style.

DNA BehaviorWithout clear understanding of each other’s financial personality and life goals, advice will always be skewed from the advisor’s point of view and, similarly, from the way the investor receives the advice.

These 16 behaviors can be revealed and managed. See those here.

Everyone, whether advisor or investor, are all subject to various forms of behavioral bias that lead us away from rational decision making and, in this case, result in less-than-optimal investment and money management decisions. An honest, transparent and successful advisor-investor relationship is one in which both parties admit and own their biases, always working to manage them.

To learn more, please speak with one of our DNA Behavior Specialists (LiveChat), email, or visit DNA Behavior.

Why not complete your own complimentary profile and see which behavioral biases may affect your financial decision-making? Click here.

The Money is Moving

Much is written about the current generation of financial advisers approaching retirement and the generation waiting in the wings to step up to fill the advisory gap.

Robert Sofia writes in his article titled Nextgen Is Coming. Are you ready?:

I must acknowledge that Generations X and Y each display distinct traits that advisors should understand and adapt to if they plan to be in business 20 years from now. Here are a few reasons why

  • Generation X and Millennial investors will inherit more than $41 trillion by 2052.
  • Surveys show that 86% of inheritors do not plan to use their parents financial advisors.
  • 29% of wealthy investors are under age 50 and control 37% of investable assets. (Source: Marsten, Cam. The Gen-Savvy Financial Advisor)

Many advisors have built their business models around serving Baby Boomer retirees and pre-retirees ? a strategy that has made sense for a long time, and will likely continue to make sense for a time. Even now, however, the landscape of Boomer wealth is changing rapidly as increasing numbers are reaching retirement age and drawing down their retirement assets.

Furthermore, as Baby Boomers pass away, it is unlikely that their heirs will invest their inheritance with their parents advisors ? unless these advisors provide services that match their expectations.

Bloombergs article titled The Fight Over Financial Literacy notes:

investment personalityMany Americans, burdened by a lack of retirement savings and more than one trillion dollars in student loans, are desperate to know how to make smarter financial decisions. Educators, financial institutions and even some savvy parents have come up with methods to instill good financial behavior. Yet there’s widespread disagreement on the most effective means of teaching kids about money. On one issue most agree: Too many Americans lack the basic knowledge to manage household finances well.

Many Generation X and Y investors have watched the plunging financial markets destroy their parents’ retirement plans; requiring them to continue working well past their longed for retirement age and dont want to be in the same position when they reach retirement. Therefore they may be very risk averse.

What does all this mean for the new generation of financial advisers? Are you prepared to navigate the different behavioral styles and emotions of your generation X and Y clients? Independent research shows that 93.6% of your role is managing client behaviors.

  • Gen X are a well-educated generation with many having qualifications. They tend to be resourceful, self-reliant and often quite skeptical of authority. They will quickly see through an adviser who is product only focused and not prepared to get to know them. But generally speaking they want to build relationships.
  • Gen Y are not noted for being loyal to a particular brand and the speed of the Internet has led this Net savvy Generation to be flexible and ever-changing in many areas of life including where and how they are communicated with. Not all business will be conducted in offices; the new generation of investors are time poor, they conduct their businesses on the run; in hotel lobbies, airport lounges, homes and expect their advisers to be able to do the same.
  • They expect great flexibility from service providers and are likely to change advisers even more frequently if trust cannot be built.
  • The next generation of financial advisers will need to be behaviorally smart. Understanding the importance of engagement with their client peers will be fundamental to ensuring they retain the client.
  • Having the flexibility and skills to communicate with the new generation of clients via social media will be key. But all communication will need to be honest and meaningful to gain their trust.

Carol Pocklington is a Human Behavior Solutions Analyst at DNA Behavior, assisting with the research and development of behavioral products. DNA Behavior helps grow behaviorally smart businesses and financial advisors worldwide to increase competitive advantage using the most reliable behavioral discovery and performance development systems on cutting-edge technology platforms. Solutions are delivered in the areas of client experience management, financial personality management and human capital management.

Visit the Financial DNA website to learn more.

New Financial DNA Developments for Addressing Risk Tolerance

Risk tolerance is a much talked about area in financial planning and it is one core component of an investor’s unique financial behavior – what we call their Financial DNA. It is so fundamental that we are always talking about it and making decisions with reference to it.

A huge difficulty has been reliably measuring an investor’s risk tolerance. One of the problems is that an investor’s risk tolerance is assessed today but then a portfolio is developed for the long term which has to cope with fluctuating markets. Do you truly know what your client’s risk tolerance for the long term is? How much of your assessment of the client’s risk tolerance is based on current situational factors and their emotional impulses today about the market? Then add in the fact that a person’s risk tolerance may differ across different asset classes. Of course, an advisor’s own risk tolerance can color the situation resulting in the client “eating” the behavior of the advisor. There have been lots of examples where a group of advisors addressing the same case facts at the same time will come up with different risk tolerance assessments for the client.

After more than 10 years of studying financial behaviors, including risk, and performing research based on our online profiles Financial DNA Resources has now launched our “Behavioral Portfolio Report”. You can download a copy of it here:

The Behavioral Portfolio Report provides a comprehensive and holistic analysis of a person’s complete financial behavioral style resulting in the creation of what we call an “Inside-Out Portfolio”. The inside-out portfolio gets to the level of asset classes and also tactical factors for investment selection. This then becomes the foundation for the financial plan and investment policy statement.

Fundamental to the Inside Out Portfolio is a superior analysis and quantification of the person’s risk perception and risk attitude. In particular, our analysis uniquely dissects their:

1. Understanding of risk and return – if this is high then they are likely to see investment markets as less risky
2. Risk propensity to take risks (or be bold) – their behavioral inclination to make daring or bold choices
3. Risk tolerance – which is the ability to live with the consequences of taking risks

Interestingly, our research has shown that in 20% of cases people have a higher risk propensity than risk tolerance. This is critical for advisors to know as their client could take greater risks than they can stomach.

Core to our Financial DNA work has been the discovery of a person’s natural “hard-wired” behavior – these are the behaviors that remain stable through a client’s life. This applies equally to risk propensity and risk tolerance.

Recently, we have had people re-take our profiles to determine profile consistency with time gaps of over 3 years. The consistency level has been very high which is powerful considering the turbulent times we have been living in.

It is key to know a client’s natural risk profile for building a portfolio as this is the behavior which will reveal itself when they are under pressure and generally throughout their life. This behavior is highly predictable. However, you do need to know the client’s current financial preferences as well based on experiences and education. This will tell you where they are at now and how much portfolio variance they can accept, and what additional guidance they may need in the portfolio construction phase.

So, our view is that you cannot know enough about your client when you are advising them. Knowing all of the dimensions of the client’s risk attitudes and objectively quantifying them is important for the “know your client rules” and more importantly to be able to have a transparent discussion with your client to properly manage their expectations. Using your intuition is very important but it alone is not enough. Now is the time to start educating your clients with much deeper and applied behavioral insight.

Know Thy Investments

The primary foundations of Financial DNA are “Know Thyself” and Know Thy Client”. However, what I have not spoken up much before about is “Know Thy Investments”. For both the advisor and the client this is absolutely critical to successful investing. Who at some point has been caught in an investment they did not fully understand and lost money? Usually, they are the “smart” investments that offer lucrative returns and/or tax breaks.

In recent times, I have had discussions with many advisors and investors who have been caught with an investment that they did not fully understand. You should forgive yourself because even the best investors have been caught at some point. This point is not just about “ponzi schemes” but also bona fide investments.

Market declines like we have had in the past year usually expose the cracks. When the market is going up the holes can often be covered up. Some of these investments are so complex that not even the creator or manager even understands them fully, let alone the advisor recommending it.

I have always said to my clients: “If you do not know what is inside the sausage do not invest”. Until a year or so ago, I did have some doubts as to whether I had been too conservative and that I was the fool for not riding the trend. Well now I am very relieved. A good example of this advice was 5 years ago when I told a very wealthy retired couple not to invest in a hedge fund that they had been offered by someone who was trying to impress them.

I do not believe most people know what they have invested in other than the belief they will make a lot of money. Many hedge funds rely on very complex models and very fine margins. Also, many change their strategy after you have invested. So that what you have invested in is not underneath the same investment as what you exit. I also know that many investors and advisors did not understand how leveraged with debt our financial markets were. All of these complex products usually have a lot of debt in them. So when the market declines, the fall can be accelerated because everyone has to get out quickly.

If you are an investor, now is a great time to review all of the investments in your portfolio and check that you truly understand them. Also, does your advisor understand your investments? Can your questions be confidently answered? I also think advisors need to take stock and totally understand what they are offering their clients. You really need to get behind the “research” reports.