The Globe and Mail by Lisa Kramer 31 July 2019
Many Canadians rely on financial advisers to navigate the complexities of investing and to help them avoid common pitfalls and mistakes. But what if those advisers are just as prone to behavioural biases as the investors they serve?
The burgeoning field of behavioural finance helps shed light on the way human nature influences people’s decisions. Because advisers are human, just like their clients, it’s no surprise advisers’ decisions might likewise occasionally fall under the influence of behavioural biases.
Yet, most research has focused exclusively on non-professional investors in documenting the ways behavioural tendencies can lead to less-than-optimal financial outcomes. Only in recent years have studies begun to consider the ways in which financial professionals may also fall prey to their biases.
Professors Sendhil Mullainathan of Harvard University, Markus Noeth of the University of Hamburg and Antoinette Schoar of the MIT School of Management sent trained auditors, masquerading as potential clients, to seek portfolio guidance from advisers as part of The Market for Financial Advice: An Audit Study, which the Cambridge, Mass.-based National Bureau of Economic Research published as a working paper in March, 2012.
Some advisers directed these would-be clients toward portfolio adjustments that were beneficial to the prospects. For example, they recommended well-diversified, low-fee investment products. However, other advisers exaggerated their existing biases and even directed these prospective clients to products that not only reinforced behavioural biases, but also resulted in larger adviser kickbacks.
You might conclude that the second group of advisers succumbed to conflicts of interest and put their own financial interests ahead of those of their clients. But a research paper titled The Misguided Beliefs of Financial Advisors, soon to be published in the Journal of Finance, implies something less nefarious may be at play.
The authors of that paper, Professors Juhani Linnainmaa of the University of South California’s Marshall School of Business, Brian Melzer of Northwestern University and Alessandro Previtero of Indiana University considered a sample of Canadian advisers and their clients. The research found that many advisers exhibited signs of behavioural biases both in managing their clients’ portfolios and in overseeing their own money.
When advisers managed both their own and others’ investments, they traded too much, causing fees to chip away at returns; sought to invest in assets that had realized high past returns, which are not indicative of future performance; failed to diversify their portfolios; and paid fees that were unnecessarily high. In addition, the advisers exhibited this behaviour even after they left the investment industry, which puts to rest the notion that advisers were reinforcing their clients’ biases because of conflicts of interest.
The idea that financial professionals are as human as the rest of us is reinforced in a research paper from Professors Li Jin of Harvard Business School and Anna Scherbina of Brandeis University published in 2006 titled Inheriting Losers. The research showed that when a new portfolio manager took over a mutual fund that had been performing badly, the portfolio manager tended to be more likely to sell the worst-performing stocks in the portfolio than a member of a comparison group of continuing portfolio managers.
That is, portfolio managers who weren’t emotionally tied to a particular stock in the portfolio because they weren’t the ones who originally decided to buy it were more inclined to get rid of that “loser” stock and replace it with a stock that offered better prospects. This finding is consistent with professionals exhibiting sunk cost fallacy or at least an unwillingness to own up to past mistakes.
All this doesn’t mean that investors should abandon their advisers and brave their finances alone. Financial professionals add value in many contexts and for many clients. However, investors should look to do business with advisers who are humble enough to concede that their decisions are prone to be influenced by their human psychology and who manage themselves actively – not just their clients’ money. These are the hallmarks of advisers who are the least likely to exhibit behaviour that’s harmful to their clients’ bottom lines.
Lisa Kramer is a professor of finance at the University of Toronto.