Like Their Clients, Advisers Display Many Biases

Too often, due to behavioral biases in action, the risk of a client not achieving a goal is behavioral, not market based, according to a new white paper published by SEI, titled “Coach Through Biases—Yours and Your Clients.’”

The analysis builds on findings from the 2019 SEI Financial Advisor Survey, as well as a recent affluent investor survey conducted in collaboration with Phoenix Marketing International. Penned by John Anderson and J. Womack, both managing directors with the firm, the paper suggests findings from these surveys “fundamentally support the case for implementing a goals-based wealth management framework.”

“As your clients’ financial coach, you can help them understand that, while the act of pursuing and maintaining risk exposure runs against their instinct to try to prevent losing money, those same instincts can undermine their ability to achieve specific longer-term goals,” the paper explains. “The need for effective coaching is apparent given the results individual investors produce.”

Indeed, as Anderson and Womack write, U.S. investors timed their sales and purchases of diversified mutual funds poorly over the past 10 years, from 2008 through 2018—a period that experienced the great financial crisis and significant market selloff, as well as calm and rising markets.

The paper points to a laundry list of different behavioral biases that impact advisers’ clients, as follows:

• Availability bias, which is a bias causing investors to judge the likelihood of future outcomes according to past experiences of similar outcomes.
• Belief perseverance bias, explained as a bias causing people to be unlikely to change their opinions even when new information becomes available.
• Confirmation bias, through which people seek out confirmatory beliefs, overlooking beliefs that don’t confirm their views.
• Herding bias, which is the idea that people feel most comfortable following the crowd; they tend to assume that the consensus view is the correct one despite rational evidence indicating otherwise.
• Hindsight bias, through which people believe they had predicted a particular outcome when in fact they had not.
• Loss aversion bias, which describes the cognitive bias that the pain of losing is more acute than the pleasure of gain.
• Overconfidence bias, occurring when confidence in one’s own judgment is greater than the objective accuracy of that judgment.
• Overreaction bias, which suggests that people are overly influenced by random occurrences and tend to over-interpret patterns that are coincidental and unlikely to persist.
• Recency bias, or the tendency to believe that what occurred in the past will continue to occur in the future.
• Regret avoidance bias, or the tendency to avoid actions that could create discomfort over prior decisions.

Advisory clients tend to display some or all of these biases in different proportions, according to the white paper. When it comes to advisers’ own decisions and behaviors, survey results suggest herding is a common bias, along with overconfidence and regret avoidance.

“While herding and confirmation bias would seem like good and easy answers, it is our position that overconfidence plays a major role in the life of many advisers,” the white paper says. “For example, over the years a category known as ‘adviser-as-portfolio-manager,’ also referred to as ‘rep-as-portfolio-manager,’ has evolved in the adviser community to identify the adviser as the portfolio manager for their clients. Many such advisers rarely tout their individual performance on a case-by-case basis, if ever.”

According to Anderson and Womack, separate research based on the analysis of 400,000 accounts over the three-year period ending Q1 2018 found that standard deviations were much higher for these adviser-as-portfolio-manager accounts and unified managed accounts where advisers manage the portfolio. In the unified managed accounts, excess volatility was in large part due to performance of the adviser-managed portfolio sleeve, according to the white paper. On the other hand, portfolios managed by dedicated fund strategists generated both attractive returns and the smoothest ride for investors.

“Fund strategist portfolios also had the tightest performance cluster, whereas [the adviser-driven] models tended to have greater performance dispersion—accounts that generated 20% in additional gains or that lost more than 20% in value,” the paper explains. “The research also revealed that volatility for adviser-as-portfolio-manager accounts was double that of the fund strategist portfolios, where the asset management is outsourced to money management professionals.”

Womack and Anderson conclude that there is “no doubt that portfolios that have significantly higher volatility relative to the markets can increase a client’s anxiety and trigger the impulse to panic.”

“The likelihood of making judgment errors increases if we neglect the impact that biases have on our own thinking,” the paper says. “This neglect can cause you to minimize important information or discount a client’s emotion as unimportant. While many behavioral biases are unconscious, being mindful that we’re all subject to them is a good place to start to help avoid them.”

The paper recommends that advisers check their egos and develop disciplined, repeatable processes that can minimize short-cut thinking. Advisers are also encouraged to make a habit of considering other possibilities and to reframe errors as opportunities to learn and grow, rather than as evidence of incompetency.

“Your role in a goals-based approach is to manage behavior to help clients maximize the likelihood of achieving success,” the paper says. “Among the behavioral tendencies most relevant to the argument in favor of goals-based wealth management is mental accounting, which describes our tendency to segment our wealth attributable to reaching various goals. As behavioral theorists have shown, investors may have multiple attitudes about risk depending on the goal in question.”

As Womack and Anderson observe, for some goals and investment accounts, risk tolerance may be low, while other goals and accounts may be associated with a high risk tolerance.

“For instance, most clients are unwilling to risk capital that has been allocated to their children’s education costs,” the paper reports. “However, they may have other accounts, sometimes described as ‘fun’ money, that they don’t need for lifestyle expenses and invest them adventurously, seeking the highest return opportunities.”