Understanding behavioural bias can help achieve a ‘real world’ picture of investors’ behaviour and motivations.
Some advisers are uncertain how exploring clients’ behavioural biases is relevant to giving financial advice. Perhaps they believe that these specific soft skills are not applicable in this context. However, we believe that, by understanding what types of behavioural biases your clients might be subject to, you may be better placed to achieve a ‘real world’ picture of investors’ behaviour and motivations than solely relying on data. This not only reflects the way the FCA wants advisers to approach the Consumer Duty, but – more importantly – helps you better guide your clients’ financial decisions.
Behavioural biases are investment behaviours that are shaped by both human emotion and knowledge. Emotional biases are illogical and irrational, but can absolutely affect the decisions your clients make. Meanwhile, cognitive biases, or cognitive errors (the lack or misunderstanding of information) by following flawed logic, are likely to skew your clients’ decisions, even though it may seem to your them that they are making the correct call. Understanding these biases can be a powerful tool for advisers when advising clients, by helping to gain a deep understanding of their motivations and how they react to market shifts.
Behavioural biases can skew investors’ perceptions, causing them to allow shorter-term market movements to dictate longer term goals. By identifying and managing these biases, advisers can steer clients for improved outcomes.
It is worth noting that, under the umbrella of Consumer Duty, the FCA mentions behavioural biases no fewer than 16 times in the Finalised Guidance, including:
1.9: “Firms should not seek to exploit customers behavioural biases, lack of knowledge or characteristics of vulnerability”
4.22: “Firms must understand and take account of behavioural biases and the impact characteristics of vulnerability can have on consumer needs and decisions”
8.10: “Firms should act in good faith and avoid designing or delivering communications in a way that exploits consumers’ information asymmetries and behavioural biases”
We therefore believe that identifying and managing behavioural bias sits firmly within the adviser’s objective of achieving good outcomes for their clients. Having an understanding of your client’s motivations and how they are likely to react to market movements is an integral – and valuable – part of the toolbox, allowing the adviser to better guide their client to the best product for them.
All clients are likely to suffer from a mix of biases; there is no ‘one solution fits all’. However, risk profiling does help create a ‘rule of thumb’ which you can use as a starting point to build on as your relationships with your clients grow.
The table below shows how risk profile-style mapping adds an extra layer of insight in relation to the influences on clients’ decision-making. This is about informing advice, rather than abiding by a rigid framework.
As you can see, the bias found in clients at the extremes of the risk spectrum typically manifests itself as emotional bias. For those with the lowest risk tolerance there are a number of emotional biases related to avoiding loss. At the other end of the spectrum, clients with a high risk tolerance are more likely have their thinking skewed by emotional biases such as overconfidence. Meanwhile, for those clients in the middle of the risk tolerance spectrum (seeking either moderate or growth outcomes), the focus is more on various cognitive biases.
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Low ---------------------------------------------------------------------- High |
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|
Risk tolerance |
Conservative |
Moderate |
Growth |
Aggressive |
|
Primary Bias |
Emotional bias |
Cognitive bias |
Cognitive bias |
Emotional bias |
|
Most common biases |
Endowment (e) Loss Aversion (e) Status Quo (e) Regret Aversion (e) Mental Accounting (c) Anchoring (c) |
Regret Aversion (e) Availability (c) Hindsight (c) Framing (c) |
Overconfidence (e) Availability (c) Confirmation (c) Representativeness (c) |
Overconfidence (e) Self control (e) Illusion of control (c) |
Summary
In summary, applying an understanding of behavioural bias is not about taking on a ‘therapist’ role, or gatekeeping specific products from certain customer groups. Understanding how particular biases can manifest themselves in clients of various profiles can help enhance advice for the betterment of your client.
Important Information
The value of investments may fall as well as rise and investors may not get back the amount invested.