In a world where clients must legally come first, advisers’ understanding of psychology and behavioural finance has never been more important
Behavioural finance is hardly a new concept for financial advisers.
The field that combines cognitive psychology theory with conventional economics and finance nearly always has a spot on most industry conference agendas.
But despite it being everywhere you look, one question remains: are advisers really adequately trained on why people make irrational financial decisions?
It is no secret that the advice industry has embarked on a journey toward professionalism, with the government’s newly-passed education standards reforms to thank.
But Mark Nagle, Treysta Financial Life Management’s executive director, believes the industry has failed to make psychology a more important chunk of an adviser’s education.
“I think it's a great shame that the FPA, for example, isn't pushing this area much more strongly in terms of the content that sits within the CFP,” Mr Nagle says.
“The industry is running around getting its knickers in a knot about the CFP and degree qualifications, but I've not heard a whisper about the fact that advisers probably need to study psychology more than they need to study finance.
“I think it's a real big miss and people should've taken a deep breath and really have the ability to change the way that advisers are being educated.”
So, why is it important that advisers learn more about human behaviour?
According to associate professor of applied finance at the University of South Australia Vikash Ramiah, the study of behavioural finance is crucial to creating the best client outcomes.
In other words, if advisers are to act in their clients’ best interests, a good understanding of behavioural finance is essential.
“It is important for financial planners to understand the behavioural characteristics of their clients to provide the best financial advice,” Dr Ramiah says.
“If we know what biases our clients have, we can prevent them from making financial mistakes, and this is where financial advice is best appreciated.”
There is a reason why behavioural finance is known to be a fairly new field.
That is because the world’s leading finance academics have historically formulated models around how financial markets work based on the assumption that all humans are always rational and make optimal decisions.
The reason why they have been slow in embracing behavioural finance is due to the “massive disconnect” between the study of psychology and the study of finance and economics, according to Behavioural Finance Australia director Simon Russell.
“In psychology, you're learning all about the nuances of human behaviour, but when you go and study economics you are given these standard models of how investment markets work, or how financial markets work and how economies work, which is all based on these normative assumptions of how people should behave – how they should respond if they are completely rational,” Mr Russell says.
“A lot of what we now know in behavioural finance, psychologists have known for quite some time. But it's taken some time for those traditional models based on fully rational optimal decision making to be overcome.”
Mr Ramiah classifies the history of finance into three schools of thought: old finance, modern finance and new finance.
He says behavioural finance was borne out of the new finance doctrine, dealing with inefficient markets and irrational behaviour primarily by adopting behavioural models.
“Behavioural finance as an academic field experienced strong resistance from the supporters of old and modern finance, who strongly believed that the market is always right and that prices reflect all information,” Mr Ramiah says.
“Any attempts to state otherwise were a threat to these academics as their training was based on the earlier older paradigms. I think these academics were fighting for their own survival but change was inevitable.”
This change came during the global financial crisis in 2008, reigniting a conversation around the ways financial markets are understood.
Mr Russell says the GFC was a huge benefit for the field of behavioural finance.
“When that happened, you had people like [former US Federal Reserve chairman] Alan Greenspan standing up and saying they got it wrong – that this model that they relied on all these years doesn't actually work and doesn't reflect reality,” Mr Russell says.
“That sort of stuff I think has helped bring what was bubbling along in academic literature for some time to the surface … that there is evidence that decisions aren’t necessarily optimal.
“We definitely need to make some tweaks around the way we think about markets and think about decisions and about decisions made by individuals, advisers and asset managers – everyone in that value chain.”
Mr Ramiah says that, in Australia, behavioural finance was considered an unorthodox discipline even as recently as the early 2000s.
He says it is amazing to see how things have changed in the past few years.
“Now behavioural finance is taught in almost every university as even the ‘old sheriffs’ have adopted these new paradigms to a degree where they consider behavioural finance notion as part of the traditional finance,” Mr Ramiah says.
What advisers need to know
In a nutshell, behavioural finance aims to identify the psychology surrounding poor financial decision making.
When an individual makes a decision that is seen to be irrational, they are seen as possessing ‘behavioural bias’.
“Behavioural bias describes human traits or behaviour where an inference is reached and an irrational decision made that leads to a suboptimal outcome,” says Bellmont Securities director David Montuoro.
“Behavioural biases often result from a perception error, where an individual forms their own construct which doesn't conform to reality.”
That is where advisers come in: great efforts need to be made from both the adviser and the client in overcoming these behavioural biases.
This might seem like it could be easily solved during the initial meeting, but according to Treysta’s Mr Nagle, the problem for many advisers is that they don’t know how to extract client values just by asking a few simple questions.
“That's a skill that you have to develop and you have to understand the psychology behind the way that you ask those questions and how you layer those questions,” Mr Nagle says.
“You need to be able to do that consistently with all of your clients, so one of the issues that advisers have is that they don't really have the tools to allow them to do that on the consistent basis that's then easy to digest and regurgitate in terms of the way they provide advice.
“So what tends to happen is that they keep relying on their own defaults, so they rely on their own values and their own biases, which then impacts the quality of the advice that's delivered to the client, even though the adviser in all good consciousness has done the job to the best of his ability.”
Mr Nagle thinks one potential source of this problem could stem from how the current compliance regime influences the way advisers collect information from clients.
“At the moment, the compliance regime around the AFSL compels you to collect a lot of financial data, and it tends to be about a bunch of hard numbers,” he says.
“Even though you're having great conversations with your clients, none of the gold within those conversations is actually being collected and then used in terms of formulating a plan for the client.
“I think that if you take the time to understand your client's values and you deliver a statement of advice, it kind of deals with product, but at the same time you're really delving into what drives that client, then you're likely to naturally leave some of those biases behind.”
But UniSA’s Mr Ramiah disagrees, saying the consequences of behavioural bias in financial advisers are negligible due to good financial regulations in Australia.
“Those who are giving financial advice have to abide by the law and proper boundaries are the solution to managing behavioural problems,” Mr Ramiah says.
“In short, clients are safe from the behavioural biases of Australian financial planners.”
For Collins SBA managing director Jonathan Elliot, he asks clients, before even talking to them, to complete two short questionnaires – one on where they are financially and one on how they feel about where they are financially.
“We get a gauge, before we even meet them, about how they feel and factually where they are,” he says.
“That is important information to have when an adviser first meets with a prospective client.”
Behavioural Finance Australia’s Mr Russell says there are so many different psychological tests and questionnaires advisers can give their clients, some of them only taking five minutes to complete.
“It creates an opportunity, but it also gives the adviser some tools to help engage with the client and help manage some of those effects,” Mr Russell says.
“Often it's not completely overcoming it as it's very difficult to overcome these biases, but least you can mitigate some of the effects.”
One US-based company has gone a step further and turned psychological testing into a card game.
Founded by Syble Solomon, the Money Habitudes cards aim to classify people’s dominant habits and attitudes towards money in identifying the key drivers to their behaviour.
Wellthy founder and chief executive Lea Schodel has become a distributor of the cards, running workshops with employers and community groups.
“With all of my clients who do this game, it tells me predominantly whether they're spontaneous or they're a really high giver or they've got someone who's got really high planning attributes,” she says.
“But it's a really interactive way to engage with a client on a non-confronting level, because you're talking about pretty personal stuff.
“By doing it in a game form, it kind of removes those barriers and you can have an open conversation about it and people laugh and bring into their awareness what they're doing unconsciously really.”
Collins SBA’s Mr Elliot also suggests advisers move outside of their own spheres of influence by visiting other people in different networks.
“Get out of the office, visit other advisers, visit other countries, visit other industries and see how business models are run and how other professionals, whether they be lawyers or accountants, engage with their clients,” Mr Elliot says.
Behavioural Finance Australia’s Mr Russell says even a simple review of your advice proposition and your client base can go a long way towards overcoming behavioural bias.
“Have a look at the documents that you're using – your statement of advice, your website. You could probably just do a checklist, and go, ‘Where are the issues and where are the opportunities?’ all the way from client engagement to working with your referral partners to how your investment committee functions,” Mr Russell says.
From maximising wealth to goals-based advice
But not everyone will agree that not enough advisers are trained on behavioural finance, with many pointing to the emergence of ‘goals-based advice’ as evidence.
Goals-based advice is known as the industry’s philosophical shift away from wealth maximisation and towards achieving client lifestyle goals.
Collins SBA’s Mr Elliot believes goals-based advice is a great way of talking to clients and getting them to open up about what’s important to them in their life.
“When we talk to clients long-term, we tend to focus more on visualising where they see themselves in terms of how they're living, the relationships in their lives and what legacy they are leaving to their family and loved ones,” Mr Elliot says.
“Then we try to bring that back to a much shorter timeframe, let's say two to three years, where we can get some specific measurable goals around financial targets.”
But Mr Elliot warns advisers to add a degree of caution to setting out long-term goals because so many things can change in that time.
“We'd be less specific with the long-term and make it more about how they want to feel in the future, but the closer we get to the present, we become more specific and metrical,” he says.
Wellthy’s Ms Schodel thinks goals-based advice forms a good basis for how to approach and work with clients.
“There are often three elements to how I look at how a client manages their money: what they think, what they feel and what they do,” she says
“You'll focus on what some of their goals are, so what they're thinking, and then also the actions around the strategies we're going to create to get you to where you want to be.”
However, Treysta’s Mr Nagle believes goals-based advice is a "horrible moving target" and is “a fad that’s likely to be short lived”.
“I think it was an effort for the industry to change their focus away from selling product to bringing the offer back to being more client-centric, and people started coming up with something that was 'goals-based',” he says.
Mr Nagle says some key lessons can be drawn from behavioural finance in recognising the flaws around goals-based advice.
“Goals-based [advice] is all very well, but there actually is a behavioural finance issue called 'affective forecasting'. It essentially means that as human beings we are actually flawed in terms of our ability to predict our own futures,” he says.
“If you ask a client to list a whole bunch of goals over the next 10 years, they're likely to get that very wrong, and that's an issue.
“You could end up saving for the caravan for your trip around Australia but when the time comes you can't think of anything that you'd least like to do than travel in a caravan around Australia.”
Instead, Mr Nagle has attempted to evolve his advice offering beyond goals-based advice towards a philosophy based around values.
“Your values are less likely to change over time, and if you create a financial framework around your values, that will give you the best likelihood of making good financial decisions,” he says.
The next evolutionary stage
As behavioural finance continues to influence the world of financial advice, it is sending the industry into unchartered territory.
Last year, Behavioural Finance Australia announced a new partnership with Bellmont Securities to deliver a new investment solution for advisers and accountants that is designed to overcome biased investor decision-making – the first of its kind.
The solution is made up of a portfolio of directly held shares, managed and structured in a way to overcome investor biases that could lead to worse financial outcomes for clients in the long-term.
Mr Russell says this allows the adviser/accountant to tailor the risk/return characteristics of the portfolio as well as the client experience.
“[The] research measures investment decision-making in controlled laboratory settings, or in large-scale real world environments, and links the findings with relevant research from psychologists and neuroscientists about how the brain functions and how people make decisions,” Mr Russell said.
Bellmont Securities’ Mr Montuoro says behavioural finance has already had a huge influence on funds management, and that it is “one of the driving forces behind the shift to the new breed of systematic funds often termed ‘smart beta’”.
He believes fund managers have an important role in educating investors around behavioural bias.
“It is critical that fund managers educate their investors about the existence and consequence of behavioural biases. This allows investors to override irrational human reactions,” he says.
Mr Montuoro says fund managers can develop investment products that factor in potential behavioural biases.
“Investing in portfolios constructed in a systematic or quantitative manner will allow investors to be protected from their own biases and exploit the biases of other investors,” Mr Montuoro says.
“These portfolios would be built using objective criteria and financial data to select stocks and free from the biases of fund managers.”
Wellthy’s Ms Schodel says there could even be a new emergence of behavioural financial planners “in the not-too-distant future”.
“If we look to the US and the UK, they already have advisers who specifically work just as behavioural coaches and support for their clients, and then they have more technical and strategic advisers to focus on the strategy and technical elements, so they've kind of separated it out,” Ms Schodel says.
“If we are looking to them as an indication of what's going to happen in the future, we can be pretty sure that that's the way that we're going to be heading.”
For Mr Elliot, while he concedes that he’s no expert in behavioural finance, he realises its importance as he grows his experience as an adviser and as a business owner.
“I'm challenging myself to get out of my normal sphere of education to actually advance my own knowledge in this space,” Mr Elliot says.
“I don't have all the answers, but it's certainly something we all need to have a heightened awareness of if we're going to serve our clients better.”
Four common behavioural biases
Overconfidence – overrating your own knowledge or capabilities
Confirmation – seeking or listening to information that confirms already-existing views or beliefs
Recency – weighing recent information more heavily when making a decision
Herding – copying the actions of a larger group
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