More On Legal & Compliancefrom The Advisor's Professional Library
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- Conducting Due Diligence of Sub-Advisors and Third-Party Advisors Engaging in due-diligence of sub-advisors isnt just a recommended best practice it is part of the fiduciary obligation to a client. An RIA should be extremely reluctant to enter a relationship with a sub-advisor who claims the firms strategy is proprietary.
Financial advisors are constantly barraged with questions from their clients like, “Why is this fund not up as much as the market?” or “Why don’t we invest in just a handful of top performing stocks to get better returns?” Behind each of these questions there could be a behavior disorder lurking.
“As a wealth manager, I have found the value of understanding the behavioral investor types of clients,” writes Michael M. Pompian, CFA, in his book Behavioral Finance and Investor Types (Wiley, 2012). Pompian’s book uncovers the personality profiles for different investors in an effort to help advisors to better comprehend client behavior.
Back in the late 19th century the theory of “homo economicus” suggested that humans are inclined to make rational financial decisions. Since then, empirical studies have shown the exact opposite; people are prone to make investment choices that aren’t always the right ones.
Let’s analyze behavioral traits that get investors in trouble:
Illusion of Control Bias (ICB)
The ICB person believes they can control or influence the outcome of their investments, when in reality, they cannot. To illustrate this, Ellen Jane Langer, a professor of psychology at Harvard University, observed how people select lottery tickets.
In one of Langer’s studies, people were allowed to participate in a hypothetical game of lottery. The individuals who were allowed to choose their own numbers were willing to pay a higher price for their tickers compared to others who were willing to have their numbers randomly selected. Although the people who chose their numbers may have felt a psychological advantage, it didn’t increase their chances of winning.
People who suffer from ICB have the tendency to trade too much. Researchers have also found they own underdiversified portfolios because they concentrate their money on stocks at companies where they work or with which they’re familiar.
Regret Aversion Bias (RAB)
Have you ever been afraid to make a decision because you weren’t sure it was the right one? This is a common symptom of the RAB investor. Oddly, their indecision ends up becoming a decision of sort.
Another error that RAB types make is they will buy an investment and hold it for too long. This can even occur with investments that have gone up in value. RAB types transform from anxious buyers into reluctant sellers because they’re scared the investment holding will increase in value after they sell it.
Individuals plagued by RAB frequently engage in herding behavior. In other words, they feel safer in popular or widely held stocks or funds in order to avoid the possibility of future regret.
In summary, if you have a client or a prospect with a poorly designed portfolio, there’s a good chance there’s a behavioral disorder or bias behind it.