A little behavioural finance knowledge is a dangerous thing

Musicians Taylor Swift and Ed Sheeran famously sang “I just want to get to know you better” in their song ‘Everything has changed’ but how much, as advisers, are we doing to know our clients better?

Life is complex and constantly changing. Every day someone is getting married, divorced, buying a house, having a baby, and burying a loved one.

Advisers are across those big moments.

They’re also across the finer details like an accident or injury, promotion or home renovation. These types of events are easy to identify and label with clear financial implications.

Where things get lost is around shifting beliefs, desires and priorities.

In this grey area, many advisers are guilty of making assumptions, based on outdated or incomplete information.

The growing acceptance of behavioural finance is a positive development because it gives advisers greater insight into the minds and psychology of investors.

Advisers are increasingly knowledgeable of behavioural finance concepts like anchoring and framing, confirmation bias and prospect theory, and the heuristic approach to problem-solving, which relies on mental short-cuts to produce solutions quickly.

The study of behavioural finance has identified over a hundred biases and heuristics.

Technology is also helping advisers record and monitor biases and changes in client attitudes and behaviours.

But there’s a danger that the mainstreaming of behavioural finance and overreliance on digital tools could lead to more assumptions.

Advisers, like other practitioners be they doctors, lawyers or accountants, are prone to reading client information or sitting back in meetings and ticking off biases and symptoms as they present. It’s akin to behavioural finance bingo.

As a result, there is a risk of making the same mistakes seen in traditional economics, where people assume they know the solution to a problem, based on a snippet of information.

In traditional economics, there is a strategy or approach to thinking about problems, however, the overuse of mathematical modelling has created a sense that there is a definitive answer.

But econometrics, which uses statistical methods to test hypotheses and develop theories, cannot solve real world economic problems. Rather it should be used to help people think about the potential consequences of different possible outcomes.

Similarly, behavioural economics can help advisers understand something about the behaviour and actions of markets but it cannot explain exactly what’s going on inside an individual’s head.

Individual investors exhibit different biases, depending on their situation. These biases can change quickly. One reason for this is the combination of cognitive dissonance (I don’t like how that makes me feel so I want another answer) and bounded rationality (I’m not going to entertain that option because I want an answer that I like). These biases represent a huge challenge because they only reveal themselves over time and are extremely difficult to identify, unless you’re really close to the client.

Financial planning is effectively applied behavioural finance.

The personal nature of quality advice requires advisers to treat clients as individuals rather than the market. They also need to understand the limits of technology, as there is no auto-pilot in personal advice.

Advisers must actively observe and listen to their clients. They must watch and read what their clients do to anticipate the questions they may ask and their reaction to stories about the economy, investments and politics.

Advisers should be vigilant about helping clients to avoid mistakes. For example, they could issue timely communications in response to significant events or emerging trends rather than stick to scheduled quarterly communications.

A purposeful, tactical approach to client communications enables advisers to direct a client’s thinking, frame or reframe information, and reinforce their service proposition.

When it comes to measuring the tangible value of advice, commentators usually try to quantify investment returns, tax savings and life insurance claim entitlements but arguably the most value comes from helping clients avoid poor decisions.

It’s a lot harder to add value after a client has been scammed or piled into a hot-tip at the height of the market.

Like any relationship, the bulk of “getting to know” activity happens at the start before complacency creeps in. In financial planning (and marriage), this is a dangerous predicament because, as the proverb goes, familiarity breeds contempt.

Advisers must consciously work to know their client and continuously challenge assumptions.

Assumptions are, after all, guesses masquerading as facts.

Paul Moran is principal of Moran Partners Financial Planning and chief executive of iFactFind.