By Keith Redhead
Keith Redhead is principal lecturer in finance at Coventry University in the United Kingdom. He has published nine books including, Personal Finance and Investments: A Behavioural Finance Perspective (Routledge, 2008). He teaches courses on behavioral finance, financial services, and institutional investments.
The paper provides a guide to the implications of behavioral finance for financial advisers. The focus is on the process of financial decision-making. Financial decision-making is seen to be subject to behavioral biases at three stages:
- The perception of information. There is a difference between objective information and perceived information. Decisions are based on perceived information. Selectivity, interpretation and closure affect perceptions. These processes are affected by behavioral biases, such as narrow framing and the availability bias along with a wide range of motivational, attitudinal, social, and emotional factors.
- Cognition. Thought is not entirely rational and is influenced by bounded rationality, the extent of cognitive reflection, mental accounting, illusions and self-deception along with other cognitive, emotional and social factors.
- Motivation. Decisions may be made but not implemented. Procrastination and mistrust can inhibit the activation of decisions.
A behavioral finance view of the financial decision-making process is depicted by Figure 1.
|Historical prices/Public information/Private Information/Noise
|Information overload could terminate the process|
Satisficing subject to heuristic simplification, self-deception, social influences, emotion and mood
There is a distinction between objective information and perceived information (objective reality and perceived reality). What people perceive is influenced by how they select information to process. People are incapable of absorbing all information, and are therefore selective as to what information receives their conscious attention. The process of selection may occur largely at an unconscious level. They need to distinguish between reliable information and noise; and to select the most important pieces of reliable information. Noise is irrelevant or inaccurate information, such as misleading rumours.
Each person will interpret information differently. Their interpretations of information are influenced by their motives, their knowledge, their experience, their feelings, and by a multitude of other cognitive, emotional, and social influences.
There is also a closure process. Where information is incomplete, people tend to fill the gaps in order to obtain a complete story. Additional "information" is used to supplement what is perceived in order to obtain closure. Some information may be disregarded if it is inconsistent with the perceived "story." The factors that influence closure are similar to those that influence the interpretation of information. What one person sees can be very different to what another person sees, even though the objective information is the same (Litterer 1965; Ricciardi 2008).
Decisions are made on the basis of perceived information. A financial adviser should be alert to the possibility that a client has inaccurate perceptions, which may need to be challenged.
DiFonzo and Bordia (1997) showed that rumours affect investment decisions, even when the rumours come from sources that lack credibility. There is evidence that people make decisions based on stories constructed around information, rather than on the information itself (Mulligan and Hastie, 2005). If a rumour is consistent with such a story or provides a story (an explanation of events), it may be more readily believed. People are prone to accept information from unreliable sources if such information is believable and consistent with their existing perceptions of events (Evans and Curtis-Holmes, 2005).
There are cognitive biases that can cause an exaggerated perception of risk. Narrow framing entails focus on short-term investment performance when the investment is long-term. An example is the person who is concerned about quarterly pension fund returns when retirement is 30 years in the future. Short investment horizons are much more likely to show losses than long horizons. A short-term focus can cause an exaggerated view of the probability of losses, and hence an increased reluctance to contribute to a pension plan.
Diacon and Hasseldine (2007) found that clients were more likely to invest when shown presentations of performance over long periods than when they were presented with a succession of short-period returns. Although more information is frequently thought to be beneficial, a financial adviser might benefit a client by making performance information infrequent.
The availability bias can also produce an exaggerated perception of risk. When making decisions, people tend to be influenced by what can be readily remembered. Vivid, much-publicized events are easily recalled. Stock market crashes are vivid, highly publicized events. Long periods of steady market advance are less vivid and less publicized. The result is that people over-emphasize crashes and exaggerate risk. An adviser can provide more balanced information in order to overcome negative perceptions arising from the availability bias.
Ciccotello (2009) provided anecdotal evidence that illustrates the availability bias. It is based on graduate students studying a personal financial planning course. He compared the attitudes of a 1999 cohort of students with those of a 2003 cohort, suggesting to both cohorts that financial plans should be based on the long-term average stock market returns of 8 to 10 percent a year.
In 1999, stock markets had experienced four consecutive years of strong performance. The students tended to reject the recommended 8 to 10 percent and chose 20 to 25 percent a year instead. The 2003 cohort of students had witnessed large market falls in each of the previous three years, and those students were reluctant to use any positive market rate of return. Both groups of students had expectations of stock market returns, which were heavily influenced by recent experience. This indicates that an adviser should provide evidence of long-term stock market returns. However the emotional impact of recent experience cannot be easily removed.
Effects of Information on Perception
A number of studies have indicated that attitude to stock market risk depends upon the recent behaviour of the stock market (Clarke and Statman 1998; Shefrin 2000; MacKillop 2003; Grable, Lytton and O'Neill 2004; Yao, Hanna and Lindamood 2004).
An alternative perspective on that evidence can be derived from research by Weber and Milliman (1997) who suggested that risk preference may be stable and that the effect of situational factors, such as stock market performance, may be caused by changes in perceptions of risk. They found that influences on investment choices simultaneously affected risk perceptions. It could be the case that attitude to perceived risk is constant, and that what changes is the perception of risk. From the perspective of providing financial advice, this implies that by correcting misperceptions about the risks of investments, a financial adviser can have a positive influence on investment decisions.
There are factors that reduce perceived risk. There is a tendency for information- even irrelevant information-to reduce perceived risk. This has been called the illusion of information. Information can be over-interpreted. The representativeness bias leads people to see patterns in random events or random numbers. Whereas the objective information is a series of random price changes, an investor may perceive a pattern in the changes. The perception of a pattern could result in a forecast when no forecast is warranted. In consequence, the degree of risk is under-estimated. A financial adviser might note that the provision of some information about an investment is likely to reduce a client's perception of risk. However the provision of too much information could cause confusion and procrastination. Information overload inhibits decision-making. Also, the familiarity bias suggests that information that is not understood is likely to deter a client. People are reluctant to buy products that are unfamiliar or confusing.
Among non-experts, risk is perceived as greater if the person lacks information about, or control over, outcomes. Lack of information and control in regard to investment outcomes leads to mistrust of providers of financial services and mistrust of financial advisers (Sjoberg, 2001). The mistrust of financial advisers may be based on a perceived affiliation bias whereby advisers are seen as being too trusting of the providers of financial services.
Some information is predominantly in the mind of the investor. The information has little objective basis and is nearly entirely perceived. This includes future income prospects. Bolhuis and Goodman (2005) cited Laibson as suggesting the possibility of unbounded optimism. This includes optimism about future income. If a client expects a substantial rise in income, that perception of future income may be used as a reason for not saving in the present. The client chooses to delay saving until the expected future income is received. In the absence of the expected increase in income, saving never takes place.
Behavioral finance takes a different view of information processing to the view taken by traditional finance. Rather than seeing people as optimizing, it sees them as satisficing (Simon 1955, 1956; March and Simon 1958). Satisficing arises from bounded rationality, which is the limited rationality that is present because people do not have the requisite intellectual capacity for fully rational behaviour. When satisficing, a person looks at alternatives and chooses the first one that is acceptable (or the best from a restricted set of alternatives). March and Simon described an alternative as optimal if it is possible to compare all the alternatives and one is preferred to all the others. Discovering all the alternatives may be too time consuming, or may even be impossible. In consequence, a person would simply find an alternative that satisfies their criteria of acceptability.
Satisficing is subject to a number of behavioral influences such as self-deception, heuristic simplification, social influence, emotion and mood (see Redhead 2008 for an overview of behavioral influences). Rationality is reduced by both limited intellectual capacity and various psychological biases that affect cognitive (thought) processes.
The departure from full rationality increases as the complexity of decisions increases. It also increases as the time available for decision-making is reduced. Time constraints reduce the ability to think about a decision and further intensify the bounds on rationality. A person facing complex decisions and time constraints experiences extremely bounded rationality. There would be a corresponding increased reliance on heuristic simplification (rules of thumb that replace rational thought). One implication is that the effects of psychological biases can be reduced by allowing the client a substantial amount of time for making financial decisions and by ensuring that the client is not presented with the need to make a complex decision.
Frederick (2005) presented evidence that the accuracy of the perception of risk is related to a personality characteristic referred to as "cognitive reflection." Cognitive reflection is the ability to resist the first impulse or intuition. It is the tendency to reflect and think about a problem rather than following initial inclinations. Low cognitive reflection is associated with a tendency to yield to immediate impulses by making quick decisions with little thought and deliberation. People who are high in cognitive reflection tend to be good at evaluating risky investment situations, and tend to be willing to take risks.
Nofsinger and Varma (2007) cited evidence that suggests a link between cognitive reflection and relative immunity from behavioural biases. They also carried out a survey, which found that professional financial advisers (personal financial planners) were above average in terms of cognitive reflection. Frederick had presented evidence that suggests a link between hyperbolic discounting (i.e. overemphasis on the present) and low cognitive reflection. Nofsinger and Varma provided evidence to support that observation.
People with low cognitive reflection fail to see the interest rate implicit in a choice between two different sums of money at different points of time (the present and a future date). Personal financial advisers should be able to see the implicit interest rates in order to provide good advice to their clients. More generally, clients with low cognitive reflection are more in need of guidance since their ability to understand alternatives and to choose between them would tend to be relatively low.
Among the psychological biases that affect investors are choice bracketing and mental accounting. In both cases, the problem is a failure to take a coherent view of the whole financial situation.
Choice bracketing causes people to evaluate each new investment independently of the existing portfolio. The result can be a poorly diversified portfolio. Although each individual decision may seem good in isolation, the aggregation of the individual decisions may represent a poor portfolio.
Mental accounting may cause incoherence in personal financial management since it can lead to financial decisions being taken independently of each other (Kahneman and Tversky 1982). If a person separates money holdings according to their uses, or sources, financial organization can lose coherence. The separation of finances may be into distinct bank or investment accounts, or may simply be in the mind of the individual. Although mental accounting can help in the organization of finances, it can also hinder rational decision-making.
For example, someone who makes an investment whilst having a debt is effectively financing the investment with borrowed money. If the person did not separate the debt and investment into separate mental accounts, the decision may have been to reduce the debt rather than buy the investment. A financial adviser would provide a useful service by pointing out the inter-related nature of a client's finances. One dimension of the provision of financial advice is teaching the client about personal financial management.
Mental accounting can result in different investments being allocated to different purposes. For example, one portfolio may be for the purpose of funding retirement whilst another is for financing children through university. Mental accounting keeps these two portfolios separate so that neither is subsidized by the other. It may be that in aggregate, the two portfolios are showing strong gains whilst one is showing a loss. The mental accounting will cause the perception of loss, in relation to a portfolio, despite the overall profit.
One frequent rule for self-control is "never touch the capital." This means that dividends and interest-but not the capital sum-should be used to finance spending. A low dividend may lead to a forced withdrawal of capital. There may have been a strong capital appreciation, but the mental accounting that separates capital and dividends could result in feelings of failure and loss. An adviser could point out that capital appreciation is an acceptable alternative to dividends as a source of financing consumption spending, and that realizing part of a capital gain need not jeopardize future income.
People may not realize that they are using mental accounting, but mental accounting determines how a person thinks about finance and makes financial decisions. People have widely differing systems of mental accounting. An adviser should be wary of thinking that a client has a conventional view of money and financial decisions. A person's mental accounting may cause unusual ways of thinking about, categorizing, and evaluating money. If financial advice is inconsistent with a client's mental accounting, the client may choose not to accept the advice (McGuigan and Eisner, 2003).
Illusions and Deceptions
Another cognitive bias is the illusion of control. The illusion of control causes people to behave as if they were able to exert control where this is impossible or unlikely; such control includes the ability to identify future out-performers. The illusion of control, together with overconfidence, may explain why so many investors choose actively managed funds when tracker funds outperform them and have lower charges.
A study by the Financial Services Authority in the U.K. (Rhodes 2000) confirmed the findings of academic studies, which found that the relative past performance of actively managed funds is no indicator of future relative performance (not everyone is convinced, see Redhead 2008). It may be that overconfidence in their own selection abilities, and the illusion of control provided by the facility of choosing between funds, cause investors (or their financial advisers) to select actively managed funds when tracker funds offer better potential value.
According to Langer (1975), people often find it difficult to accept that outcomes may be random. Langer distinguishes between chance events and skill events. Skill events entail a causal link between behaviour and the outcome. In the case of chance events, the outcome is random. People often see chance events as skill events. When faced with randomness, people frequently behave as if the event were controllable (or predictable). If people engage in skill behaviour, such as making choices, their belief in the controllability of a random event appears to become stronger. There is considerable evidence that investment managers are unable to consistently out-perform stock markets. This suggests that the outcome of investment management is random. However, since the investment managers engage in skill behaviour, analysis and choice, they tend to see portfolio performance as controllable. Retail investors and financial advisers are also likely to see the performance of their investment choices as controllable; the act of choosing enhances the illusion of control.
Overconfidence is commonplace. Investors can be overconfident about their forecasts and opinions. Overconfidence can be reinforced by the hindsight bias. Hindsight bias causes people to believe that past events were capable of having been forecast (even when they were not possible to forecast). In consequence, clients may question why their financial advisers failed to forecast the events.
Overconfidence and the illusion of control can be reinforced by confirmation bias. Confirmation bias is a tendency to interpret information as confirming a preferred point of view and an inclination to seek information that confirms the opinion whilst discounting contradictory information. An adviser could attempt to combat overconfidence and confirmation bias by asking the client to consider both the opposite point of view and the consequences of being wrong (Moisand 2000).
A person may make a decision but not act on it. Some motivation is required for action. Behavioral finance has identified the presence of procrastination and inhibition in the activation stage of investment decisions. Even when decisions have been made they will not be implemented unless the positive motivation is strong enough to overcome inclinations and feelings that inhibit action (Neukam and Hershey, 2003).
The status quo bias and conservatism tend to inhibit action by predisposing the investor against change. The status quo bias is the inclination to retain an existing investment in preference to switching to a new one. Possession of something tends to enhance its perceived value. Conservatism is reluctance to change an opinion. Fear of change, and fear of the process of change, can prevent action. This is particularly so if there is uncertainty about the costs and benefits of a decision. Confirmation bias can produce an over emphasis on the case against change.
One aspect of prospect theory is the relative weighting of gains and losses. Typically, losses are emotionally weighted more than twice as much as gains of equal size. This is referred to as loss aversion. So if there were a 50 percent probability of gain and a 50 percent probability of loss, an investment would not be made. Loss aversion inclines people to inaction rather than action.
Financial activation motivates saving for retirement, whereas financial inhibition discourages saving. Financial activation is goal-based, and financial inhibition is fear-based. They are two distinct characteristics rather than two ends of the same dimension.
Neukam and Hershey found that that the people who saved most were those with the strongest financial goals and the lowest level of fear. In relation to retirement saving, visions of old age are likely to affect financial goals. A vision of prospective poverty might strengthen the goals of saving as might visions of a leisure-orientated lifestyle in retirement. Conversely, images of poor health and fading looks in old age could produce inhibition since people might put old age out of their minds. If they do not think about the retirement years, they may not save for them. The goals and fears were not only related to visions of old age, but also to the planning process. The personal characteristics interact.
For example, a strong drive toward saving (planning) for retirement could be offset by a high level of fear about the planning process; a strong desire to accumulate wealth for retirement could be offset by a fear of stock market risk or a distrust of the financial services industry. This latter point is close to the Harrison, Waite and White (2006) observation that mistrust of financial advisers can deter retirement saving. The importance of fears concerning the saving (retirement planning) process relates to the Jacobs-Lawson and Hershey (2005) findings that financial knowledge and risk tolerance are positively related to retirement saving.
Many people exhibit a strong emphasis on the present. Receipt of $50 immediately may be preferred to $100 next month, whereas $50 next month would not be preferred to $100 in two months. This inclination toward gratification in the present is seen to arise from a lack of future time perspective (Jacobs-Lawson and Hershey 2005) or from hyperbolic discounting (Ainslie 1991).
Benartzi and Thaler (2004) used the principles of behavioral finance to develop a practical program for increasing the level of saving into pension schemes. The program is called Save More Tomorrow (SMarT). It was designed to help employees who want to save more for retirement but find that their willpower is lacking.
One feature of SMarT is that there is a time lag between commitment to the scheme and the date on which payments begin. This overcomes the problem that people tend to value immediate money very highly. People find it easier to commit to a future investment than an immediate one.
A second feature is that increases in payments to the scheme coincide with pay rises. By using part of a pay rise, contributors do not feel that they are reducing their disposable income (take-home pay). This avoids the aversion to loss identified by prospect theory. It does not seem to matter whether the pay rise is a real one, or simply matches inflation, since people seem to suffer from money illusion. The real rise is the increase in the purchasing power of the wage; if prices are rising, the real rise is less than the rise in money terms. Money illusion causes people to see money rises as real ones. Evidence for money illusion has been found by Kahneman, Knetch and Thaler (1986) and by Shafir, Diamond and Tversky (1997).
A third feature is that the contributions to the pension scheme increase every time there is a pay rise, until a predetermined maximum proportion of income is reached. The status quo bias indicates that, when faced with a choice, people tend to do nothing (i.e. they maintain the status quo). This causes procrastination. If the decision has already been made to increase contributions to the scheme, maintenance of the status quo entails proceeding with the existing arrangement to increase contributions.
A fourth feature is that employees can opt out of the plan if they wish to. This makes commitment to the scheme less binding, and hence makes the commitment more likely. The status quo bias tends to keep people in the scheme.
If action requires operating through an agent, there is inhibition if the agent is not trusted. Such agents could include financial advisers and financial organizations that provide financial products for retail investors. Trust can be an important factor in determining whether action is taken (Olsen 2008). For example, a person may decide to start a pension plan. However if that person does not trust financial advisers, the result could be an absence of action.
Mistrust inhibits action. The lack of trust might relate to the competence of financial advisers, or to the ability of advisers to put clients' interests ahead of their own. Trust entails the acceptance of vulnerability to the decisions of others. If the investor cannot trust the competence or integrity of an adviser, the pension plan will not be implemented. There also needs to be trust in the organization that provides the pension plan. There needs to be trust in regulators and in the markets in which the underlying investments are made. Although an investor may wish to invest in a pension plan, distrust of the stock and bond markets in which the provider invests could deter the investor from pursuing the pension plan. One of an adviser's tasks is to improve the client's trust in the various agencies involved in the delivery and provision of financial products.
Financial advisers paid by commission have a conflict of interest. The products that are best for the client are not necessarily those that pay the highest commission. It might be argued that advisers should have sufficient integrity to consider only the interests of their clients, but even the highest integrity does not eliminate bias.
Research into the behaviour of auditors has indicated that the psychological processes involved in conflicts of interest can occur without any conscious intention to indulge in corruption (Moore, Tetlock, Tanlu and Bazerman 2006). Confirmation bias, which entails a focus on supporting information and rejection of opposing information, is not a conscious process. Montier (2007) has referred to the notion that people are able to exclude self-interest in decision-making as the illusion of objectivity. Biases from motivated reasoning are widespread; evidence exists for their presence amongst medics and judges. The human mind is not a disinterested computer; its operation is affected by moods, emotions, motives, attitudes, and self-interest.
The inclination of financial advisers (and everyone else) to consider their own interests is often referred to as the self-serving bias. Most people try to be fair and objective, and like to feel that others see them as acting fairly and objectively. However, attempts to be fair and objective are undermined by psychological factors of which people are unaware. The self-serving bias inclines people (unconsciously) to gather information, process information, and remember information in such a way as to satisfy their self-interest. Evidence that supports self-interest may be accepted without question, whilst contradictory evidence is closely scrutinised (Koehler 1993). The self-serving bias, as other behavioral biases, tends to be stronger in situations characterized by complexity and uncertainty (Banaji, Bazerman and Chugh 2003).
A client will not trust an adviser unless the adviser is seen as ethical. The perceived integrity of a financial adviser is dependent upon the perceived ethical standards of the adviser. Although good intentions are necessary for ethical behavior, they are not sufficient. Cognitive limitations and biases, including the self-serving bias, can lead to unethical behaviour even when the intention is to be ethical. Many people accidentally blunder into unethical behaviour (Prentice, 2007). A complicating issue is the tendency for people to be overconfident about their ethical standards. The self-enhancement bias not only leads people to believe that they are above average in their abilities, but also that they are above average in the maintenance of ethical standards (Jennings 2005). If people are overconfident about their ethical standards, they may be less inclined to critically examine their behavior; "I am a good person, so what I do must be ethical."
Often people will rationalize unethical behaviour in order to preserve a self-image of being ethical. Rationalization is alternatively known as self-justification. Anand, Ashforth and Joshi (2005) described some types of rationalization. They included denial of responsibility; e.g. "It is not my choice, it is the way the business operates," or "The client makes the final decision," or "The law allows it, so it is the fault of the government."
Another rationalization is denial of injury; e.g. "I know the fund charges are high, but the good fund management will more than compensate."
There is denial of victim; e.g. "The client does not pay the commission, the life assurance company pays it," or "Customers are clever, they are not fooled."
There is appeal to higher loyalties; e.g. "I have a family to keep."
Another form of rationalization is the metaphor of the ledger; e.g. "The value of my advice is greater than the value of the commission."
Colleagues and authority can undermine someone's ethical standards without the person being aware of the process. There is a conformity bias whereby people conform to the values and behaviors of those around them, including colleagues. A person could unconsciously adopt the unethical behavior of others. Obedience to authority figures, such as employers and managers, can be a strong tendency. Even when explicit instructions are not given they may be inferred (Tetlock 1991). Strong emphasis on sales targets could be taken as implying that sales volume is more important than other factors such as business ethics.
The conformity bias can result in groupthink (Janis 1982, Sims 1992). Groupthink entails a uniformity of thought and values within a group. In business settings, bonding activities such as awaydays reinforce groupthink. If the thinking of the group were unethical, a new member would tend to adopt the unethical thinking. The concurrence of other group members in a set of values could lead to the belief that those values are ethical. Risky shift is the tendency for a group to take bigger risks than individuals within the group (Coffee 1981). Group action dilutes an individual's feelings of responsibility (Schneyer 1991). The increased risks include increased ethical risks. Clients might be advised to make risky investments.
A tendency to advise clients to take more risk than is appropriate could be reinforced by the optimism bias. This can manifest itself in an understatement of risk (Smits and Hoorens 2005) and an exaggeration of profit potential. The optimism reflects genuinely held beliefs on the part of the financial adviser. Corporate insiders may provide over-optimistic forecasts because they really believe them, rather than because they intend to deceive investors (Langevoort 1997). The same may be true of investment analysts (Prentice 2007) and financial advisers.
MacCoun (2000) suggested that the chances of removing cognitive biases from people's thinking are very low. One implication is that regulation, to protect consumers from cognitively biased advisers, is necessary. If regulation improves client trust, everyone could benefit, but regulators must also be aware of behavioral biases.
The principles of behavioral finance throw light on the effectiveness of specific regulatory measures. For example, in the U.K., financial advisers are required to tell clients how much commission the advisers expect to receive. Laboratory studies have indicated that clients follow the advice of advisers to nearly the same extent as they would in the absence of knowing about the conflict of interest. Also, advisers seem to feel less compelled to be impartial when the conflict of interest has been revealed. The presumed increased scepticism on the part of the client is seen as reducing the need to be impartial (Bazerman and Malhotra 2005; Cain, Loewenstein and Moore 2005).
Financial advisers would improve their service to clients if they correct biases arising from the psychology of perception (perceived information), the psychology of cognition (information processing), and the psychology of motivation (activation).
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