Helping Financial Advisers and Clients Avoid “Financially Dysfunctional Behavior”

Back in May 2011, a group of academic researchers, educators, financial advisers, and regulators met to discuss a vexing, but critical, issue: how household financial decisions might be improved through a combination of better education, advice, and oversight of business practices. The result is Life-Cycle Investing: Financial Education and Consumer Protection, published in November 2012 by the Research Foundation of CFA Institute.

The conference focused on low- and middle-income households. But, as Laurence B. Siegel, research director at the Research Foundation, notes in the foreword, the proceedings are “invaluable reading for anyone concerned with the well-being of people in the their roles as savers and investors.” (Financial advisers, read: clients.)

One of the challenges investment professionals face is figuring out effective ways of helping some clients become smarter about their decisions. This is key to offsetting what Nobel Laureate Robert C. Merton, a keynote speaker, calls “financially dysfunctional behavior.”

With that in mind, here are some points to consider, based on the presentation by Stephen Horan, CFA, CIPM, head of university relations and private wealth at CFA Institute:

• Optimal investment behavior is limited and governed by behavioral biases, which include flaws in our financial memory, the recency effect, hindsight/attribution bias, confirmation bias, and overconfidence. Horan pointed out that professionals, including CFA charterholders, “are every bit as susceptible to these behavioral biases and cognitive flaws as are non-professionals.” (For a “bias” refresher, you may want to check out Bob Seawright’s blog post on investors’ 10 most common behavioral biases.)
• Numeracy and economic literacy are key and should be promoted. “These basics constitute the foundation for informed choices and outcomes,” Horan said. He suggested keeping education simple and focused on the basic concepts, including: compounding; what a safe investment really is (not necessarily a T-bill); what diversification actually does and does not do; and dollar cost averaging. Also, he says it’s important to educate clients about the need for advice and to assist them in becoming better consumers of this advice by helping them understand the scope of services that are provided, any conflicts of interest, and the education and training of various types of advisers.
• Advisers, not just their clients, need ongoing education — on ethics and standards of professional conduct, as well as behavioral biases, especially those that pertain to the investment community.
• Simple tools can help improve investment behavior. For example, create an investment diary, in which “you write down every single investment decision you make: what the decision was and why you made it (for example, buying gold because you think there is going to be hyperinflation in the future),” Horan said. “You also document in the diary what the risks to that investment are. If you have ever kept an investment diary and then gone back and revisited that diary a year later, you will have had a very humbling experience because the diary lays bare your own faulty recollection of how good and how reliable your decisions are. Keeping a diary will make you less selective in terms of how you recall your investment performance.”
• The use of investment policy statements and spending diaries should be encouraged. “If we promote these simple things, we will end up with more informed investors and better investment decision-making,” Horan said. (See our guides to writing investment policy statements for individual investors and institutional investors.)

If you are interested in learning more about life-cycle investing, here are additional resources from the Research Foundation:

• Life-Cycle Investing: Financial Education and Consumer Protection (2012)
• The Theory of Optimal Life-Cycle Saving and Investing (2008)
• The Future of Life-Cycle Saving and Investing (2007)

Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Photo credit: ©iStockphoto.com/MaryLB