As advisors incorporate behavioral finance more into their practices, their focus has been almost 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 those investors’ harmful behavioral inclinations. However, advisors large and small may have their own biases—which are tied to the way they run their businesses and their own financial incentives. Their very investment philosophy and the types of portfolio advice or services they offer could reveal their biases too.
As all advisors already clearly understand, 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 advisor’s profit may not be the same for all those investment choices, and that’s where the bias can creep in, whether or not the professional acknowledges it.
The most obvious case shows up in direct sales incentives, where certain strategies generate higher fees or income for the advisor. However, even advisors operating entirely on AUM fees or retainers may be signaling to their clients that they have certain abilities to predict the future. After all, any investment style that diverges from passive asset allocation and security selection in effect presumes the advisor is offering some level of predictive ability. Even if the advisor assumes that an asset class like stocks will outperform cash over the long term, that’s still technically a form of prediction. And 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. Researchers have observed both in investors, who tend to 1) presume they have more skill in prediction than is in fact warranted and 2) think that what could be argued to be random outcomes are actually under their control.
Advisors can avoid both these biases by using 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 have been over time, just one article with the opposite conclusions can allow the mind to ignore the preponderance of evidence and instead focus on one contrarian example as proof that passive may not always work (which is certainly a true statement). Much to the discomfort of us all, confirmation bias arises in all 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, even so, the advisors can still provide a lot of value to clients by helping them avoid their own worst behavior. As for the tax angle we mentioned, advisors can still provide a benefit by recommending 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. Clients dealing with a loss of wealth often develop a distorted view of time, focusing excessively only on the short historical time horizon when they’re upset. In those cases, advisors can often counter a client’s “recency” bias by re-emphasizing their long-term goals.
Investors and advisors can both benefit from some self-awareness about our biased thinking and motivations. Unfortunately, part of how our brains are wired means that it’s generally much easier (and more gratifying!) to spot bias in others 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. But 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.