Keeping your own bias as an adviser in check

So much so, that the psychology of an investor could have a negative impact of around three percent on portfolio performance. This is a significant impact – the study shows that the difference could halve an initial investment over 20 years.

But what happens when you, the financial adviser fail to keep your own biases in check?

The research team at investment research firm, FE are engaged in the study of investment funds and often bear witness to cognitive and emotional biases displayed by fund managers and investment advisers. Charles Younes, research manager at FE highlighted the three most prevalent biases as confirmation bias, mental accounting bias and loss-aversion bias.

Confirmation bias: occurs when you look for or distort new information to support an existing view. It often is due to overconfidence in personal beliefs and works to maintain or strengthen beliefs in the face of contrary evidence. For example, this can lead fund managers to stick with declining stock far longer than they should because they interpret every bit of news about the company in a way that favours the company’s prospects.

Mental accounting bias: Behavioural economist Richard Thaler says mental accounting can be defined as our tendency to treat various pools of money differently, depending on where the money comes from and how we intend to use it. This can have an adverse effect on a client’s portfolio as follows:

• Keeping too much money in a cash emergency fund rather than putting it to work in an investment account or paying down high-interest debt.
• Avoiding risks when it comes to an emergency fund, but overdoing risk in an investment account, leading to suboptimal investment decisions across all the various groups of monies.

Loss-aversion bias: arises from feeling more pain in a loss than pleasure in an equal gain. Kahneman and Tversky*  found that humans feel the pain of a loss about twice as much as they feel the pleasure of the same sized gain. This refers to the tendency for people to strongly prefer avoiding losses than acquiring gains.

What can you do as an adviser?

According to a thesis from the Helsinki School of Economics on the behavioural biases of investment advisers, the fact that the different behavioural biases can lead to overconfidence has serious impacts on the financial decisions of clients depending on your advice. However, knowledge about behavioral biases can reduce your biases and this highlights the importance of training and self-awareness.

Adoption of a considered, consistent and disciplined investment process based on risk management and achieving the clients’ goals, can mitigate cognitive and loss-aversion biases. To overcome mental accounting bias – a total return approach should be used alongside strong portfolio construction skills. This is where you seek to maximise gains from both income-generating investments, such as bonds and dividend paying stocks, while simultaneously aiming to invest in assets which will experience capital appreciation.

If you don’t have the time or confidence to manage and mitigate these behavioural risks, you can outsource the investment selection process to research partners and discretionary managers with specialist skills and resources to monitor and manage portfolios on a daily basis. For example, you could make use of Discovery’s range of model portfolios.

Disclaimer
Nothing contained herein should be construed as financial advice and the article is meant for information purposes only. Discovery Life Investment Services Pty (Ltd): Registration number 2007/005969/07, branded as Discovery Invest, is an authorised financial services provider.