Behavioural science is the study of how people make decisions. It’s taken off in recent years as a mandatory course of study for many financial advisors. To help them, firms are developing tools to assess client biases and companies too have developed extensive continuing education programs to address the demand for more information about how clients behave in times of uncertainty.

Documenting the biases we have has been the focus for many, but behavioural scientists are also moving beyond biases to examine how goals are identified and formed during typical advisory fact-finding exercises. They’re also delving deep into ways of making risk tolerance conversations more meaningful.

Biases though, are still a good place to start when trying to understand why a client might choose to sell during a down market or buy when things are peaking.

Limited attention, willpower and reasoning ability

“We can’t devote all of our time to considering every option for the millions of decisions we make every day. So instead, we cope by using shortcuts or habits.” - Samantha Lamas

“We have limited attention, willpower, memory and reasoning ability,” says Morningstar Inc. behavioural researcher, Samantha Lamas. “We can’t devote all of our time to considering every option for the millions of decisions we make every day. So instead, we cope by using shortcuts or habits.” Lamas was part of a virtual roundtable on behavioural science at a recent Morningstar investment conference.

“For the decisions that we don’t have a habit for, we use a shortcut. Usually those shortcuts lead us to the right conclusions,” she adds. “When we’re dealing with limited information, high uncertainty and too many choices, using a shortcut is what we should be doing. Usually it will lead us to the right conclusion. However this doesn’t always happen in investing.”

Using restaurant reviews to choose where you’re going to eat, for example, is a solid enough way to make a decision about your next meal. Following the crowd however, herding behaviour, is not an ideal way to choose your investments or to decide if you are going to remain invested at all.

“Herding bias is the tendency to put too much weight on what other people are doing and then follow that,” says Morningstar’s head of behavioral science, Stephen Wendel who lead the behavioural science roundtable. “When you don’t know (something) yourself, you can look to others for a cue. In everyday life that’s great, but in investing, of course, that can lead to bubbles, it can lead to fads. It can lead to tremendously bad outcomes.”

Morningstar, in its guide, the Behavioral Guide to Market Volatility: How Behavioral Science Can Help Advisors During Market Turmoil, says volatile times can make investors even more prone to behavioural mistakes. “An overworked, tired, and distracted mind is bound to take more shortcuts than usual,” they write.

Examining fact-finding exercises

Looking past simple shortcuts, behavioural scientists are also interested in examining the fact-finding exercises advisors undertake with their clients.

Dan Ariely is a professor of behavioural economics, bestselling author of several books on irrationality, and co-founding partner and chief behavioural scientist with BEworks, a company which recently partnered with Manulife to provide advisors with information to better understand investor behaviour.

He says advisors often drag the discovery period with new clients out far too long. “We found that (advisors) did not have an appreciation for getting people to act quickly,” he said during a recent webinar hosted by Manulife Investment Management. “They would do much better if they could get people to do something after the first meeting. By delaying, by creating lots and lots of meetings, they think they are building confidence, but what they are doing is repeating a pattern of not making a decision.”

Risking life outcomes

He also suggests that risk tolerance questionnaires may not be terribly useful since clients generally don’t think in terms of percentage gains and losses. People, he says, do not risk their money, they risk their life outcomes. “How can I live in retirement? What kind of school can I send my kids to? Can I give money to charity? Can I travel? That is what people make decisions about. They do not make decisions about how they would feel when the market moves 20 per cent.”

Morningstar research, meanwhile, shows that client goals are often greatly impacted by recency bias, that is the tendency to overweight or give the most attention to events that have occurred recently.

“When we’re confronted with such a difficult question – what are you saving your money for in the next 30 years – we take a shortcut. We rely on what’s top-of-mind,” Lamas says. “When we input a brief behavioural intervention into that goal generation process, we found that more than 70 per cent of people change at least one of their top three goals. That means that a majority of people can be working towards the wrong goals right now.”

In Morningstar’s research, investors were asked to write down their top three investing goals. After that, they were given a master list of common investing goals – the brief behavioural intervention that Lamas is referring to. Following that intervention, investors were then asked to revisit their top three goals. Most ended up changing at least one of their top goals after going through the exercise.

For advisors trying to navigate this and other vagaries of client psychology, experts have a number of suggestions:

1. Don’t flex. Although it may be tempting to show and explain to clients the complexity of their situation in an effort to show off your own skill, experts say this is simply a great way to frighten people about what is going on. Kelly Peters, BEworks co-founder and CEO says the firm’s most recent research shows the more an advisor flexes his or her authority in this way, the less likely clients will be to follow their advice. “There is a whole bunch of other measures that we looked at in our study,” she adds. “How they trust you, how they value your advice, their intention to consult with an advisor again, the perceived benefits of getting advice – all of those measures actually go down (when you) try to exert this authority.”

2. Be simple and directive. Explaining more is not the answer, Peters adds. Being very simple, really directive and then repeating your (simple) guidance three times is the most effective way to get clients to take action. “Being simple increases their trust in your expertise and your knowledge, the likelihood they’ll follow your advice and consult you again, and the overall benefits of actually working with a financial advisor. By being simple, you are seen as being smarter.”

3. Use pre-commitment exercises. The range of pre-commitment exercises that an advisor can engage in with their clients can include your investment policy statement (make it personal, make it detailed, include what you intend to do in the face of losses and consider including what the client cares about – why they’re going to the trouble of creating a financial plan in the first place), or a previously executed agreement between advisor and client that the advisor will do anything the client asks (within reason) only after a three day cooling off period has passed.

Getting clients to write a letter to themselves about their goals and long-term objectives can also be helpful when the time comes to help them visualize their goals later on. “Bring out the meaning behind each dollar,” Morningstar writes in its behavioural guide. “Labeling accounts with the investing goal that this money will achieve makes it easier for investors to stay connected to that purpose when volatility arises. A reminder that selling investments from a particular bucket means taking money out of the college fund may be the nudge investors need to stay invested.”

4. Add friction. Pre-authorized contribution arrangements are an often-cited way to keep clients invested throughout a market downturn, as it takes some effort to actually cancel such contributions in the moment. Morningstar also suggests that a gentle reminder about a trade’s tax consequences, if there are any, can also help a client to think twice about selling. Betterment, an online investing company, they say, found that people hate paying taxes even more than they dislike the prospect of losing value in a further market downturn.

If a client is still bent on selling, ask them then to explain the flip side of the coin – ask them to give three reasons why they shouldn’t sell, or ask them to explain why another investor might be interested in buying the securities in question. Morningstar’s report says the technique “is a great way to combat confirmation bias. If your client mentions that many of their acquaintances have cashed out, ask them to think about why it might be a bad choice to follow them.”

5. Educate your clients. Finally, long before a client comes to you full of anxiety over the latest market fluctuations, it can be beneficial to engage clients in a conversation about biases (all humans have them) and how they can impact financial decision-making. Wendel points out that it is not ideal to tell clients they’re making a mistake in the moment, but rather approach the discussion during a calm period, and point out that biases are a universal problem affecting everyone. “Many investors don’t appear to recognize that their investing decisions are impacted by their emotions,” Morningstar writes. “Investors don’t understand the importance of advisors helping them manage their emotions.”