As advisors incorporate behavioral finance more in their practices, the focus has been entirely on the potential harm investors might cause themselves through their own biases. However, advisor biases can present challenges too, although they may manifest differently than the ones that affect investors. Naturally investors focus on their own experiences in capital markets, and good advisors have learned how to counter harmful behavioral inclinations in their clients. However, in addition to their clients’ behavioral biases, advisors large and small may encounter their own biases tied to the incentives inherent in how they run their businesses. The very investment philosophy and type of portfolio advice or service an advisory firm offers can potentially introduce bias.
As all advisors already understand clearly, there’s no such thing as a single and clear-cut approach to constructing portfolios. An incredible variety of asset types and vehicles are available to create what theoretically would be the ideal risk-adjusted portfolio for a particular client. However, the profit to an advisor may not be the same across all those investment choices, and that’s where the bias can creep in, whether it’s acknowledged by the advisor.
The most obvious case of such bias shows up in direct sales incentives, where certain strategies generate higher fees or income for an advisor. However, even advisors who operate entirely on an AUM fee or retainer model may prefer to signal to their client’s certain abilities to predict the future. After all, anything that diverges from both passive asset allocation and security selection in effect presumes some level of predictive ability. Even assuming that over the very long term an asset class like stocks will outperform cash is still technically a form of prediction. As advisors seek to attract and retain clients, there’s naturally a risk of behavioral bias when it comes to assessing their own predictive abilities.
In the published research on behavioral finance, two distinct but related forms of bias apply here: overconfidence and the illusion of control. Of course, both were originally observed by researchers in investors, who tend to 1) presume more skill in prediction than is in fact warranted and 2) view what could be argued to be random outcomes as actually under their control.
Advisors can avoid both biases through careful analysis and research, but even that might be swayed by what researchers in behavioral psychology label as “motivated thinking.” In his insightful book How We Know What Isn’t So, Thomas Gilovich cites research on the tendency in all of us to ignore evidence that doesn’t support what we want to believe, also known as confirmation bias. For example, if an advisor reads many research articles showing how successful passive strategies may have been over time, just one article with the opposite conclusions can allow the mind to ignore the preponderance of evidence and focus on one contrarian example as proof that passive may not always work (certainly a true statement). Much to the discomfort of us all, confirmation bias arises across belief systems, so it’s a trap into which we can all fall, not just the proponents of active investment strategies.
Another example of bias and motivated thinking shows up in how frequently after-tax returns get ignored in calculations and discussion of investments held in taxable accounts. I’ve heard advisors share that they don’t want their clients understanding things like the tax impact of certain hedge fund strategies, since that would make those strategies look less appealing.
While we’ve highlighted how easy it can be for advisors to exhibit the same biases as investors, for some of the documented biases advisors can still provide a lot of value to clients by helping them avoid their worst behavior. Regarding the tax angle just mentioned, advisors still can provide benefit through recommendations on things like 529 plans or choosing between taxable and municipal bonds. In addition, any veteran advisor can share stories about helping clients who panic during market meltdowns by soothing a client’s anxiety and reminding them to focus on the long term, a way to counteract the negative effects of the loss aversion bias. In addition, such clients suffering from dealing with the loss of wealth often develop a distorted view of time, focusing excessively while emotionally upset on only a short historical time horizon. In those cases, advisors can often offset recency bias in clients by emphasizing long-term goals.
For investors and advisors both, we can all benefit from some self-awareness of our tendencies toward bias and motivated thinking. Unfortunately, part of how our brains are wired means that it’s generally much easier (and more gratifying!) to spot bias in others rather than in ourselves. Applying the framework of behavioral finance shows that advisors can provide great value to clients by countering the tendency of investors to fall into behavioral traps. By focusing on biases in both their clients and themselves, advisors can provide even more beneficial service to clients, which of course is the aspiration of the entire profession.
Patrick Geddes is the co-founder and former CEO of the Aperio Group, a $44 billion investment manager that works primarily with ultra-high-net-worth and institutional investors.