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How Behavioral Biases Affect Financial Professionals

Apparently participants aren’t the only ones struggling with behavioral biases, according to a new report.

The paper, authored by H. Kent Baker (American University Kogod School of Business), Greg Filbeck (Pennsylvania State University) and Victor Ricciardi (Goucher College Department of Business Management), assert that financial and investment professionals — along with their clients — reveal a wide array of psychological biases that can result in flawed judgments and decisions.

Specifically as it relates to financial advisors (portfolio managers and institutional investors are examined separately), the authors cite the following areas of potential “bias.”

The authors claim that finance professionals tend to exclude specific information or process information incorrectly when advising clients, a situation is associated with a cognitive tool of decision-making in which individuals apply heuristics or mental shortcuts when processing large amounts of data or statistics that often result in mental mistakes. They note that these judgments are “regularly” applied to assess and forecast investment risk tolerance of their clients; for example, that married individuals are less risk-tolerant than singles and recommend more conservative investment products.

Anchoring. The tendency for experts to have a belief and then apply it as a reference point for making future judgments — is cited as another area of vulnerability. The authors note that because advisors often base their decisions on the first piece of information they receive (such as a stock’s initial purchase price), they have difficulty modifying their assessment to new information, and when they “anchor” on a losing investment as a bad experience, they can become excessively risk- and loss-averse.

Perceived Risk. The authors cite a separate study that investigates the association between the judgment process and various aspects of investment classes and financial assets, in particular expert perceptions of returns, risk and risk/return relations, and finds that three major variables — worry, knowledge, and volatility — explain 98% of the financial advisors’ perceived risk for different financial products and services.

Familiarity Bias, Risk and Return. The report notes that financial planners, advisors and their clients often have a preference to own familiar assets, a tendency that the authors say may result in under-diversification in their investment portfolios and lower performance.

Framing. Framing is how financial planners and advisors present a financial service or investment product to a client based on specific word association. The authors cite a study by Roszkowski and Snelbecker (1990) that examines the influence of the framing process by comparing the gains and losses of 200 financial planners. While financial professionals commonly exhibit similar framing effects, they are more conservative in their approach to managing the client’s investments than their own money, according to the analysis.

Worry. The report cites a separate study that found that a large majority of investors associate the term “worry” with stocks rather than bonds, and that this higher degree of worry for a stock increases its perceived risk, lowers the degree of risk tolerance among investors, and decreases the likelihood of owning the investment.

The report concludes that understanding these biases is important for these professionals to ensure their clients are receiving the best advice and information. Significantly, evidence reveals that as investor sophistication increases from individual investors to institutional investors, behavioral biases decrease and even disappear, and that because institutional investors tend to make rational, information-based decisions, they do not suffer from common behavioral biases displayed by individual investors.

That, the authors conclude helps make markets more efficient. It also suggests that, having made the effort to acknowledge and counter these biases, help their clients — both plan sponsors and participants — make better decisions as well.