More choice isn’t always better

Your clients may be worried about economic factors beyond their control, but they may want to start looking a little closer to home—according to neurofinance, an emerging field of behavioural finance, our own brains can expose us to unexpected financial risks.

Since the 1990s, behavioural finance has taught us that we need to consider our own biases when making financial decisions. Factors such as the endowment effect, which causes individuals to overvalue items, and overconfidence, can impact our investment decisions and success.

Neurofinance explores how judgment errors can be caused at the most basic levels.

For example, investors do have the tendency to overvalue their stock and their choices, causing them to hold onto a security too long or else trade it too frequently. However, one study revealed that simply being shown a sad or disgusting image can affect a client’s ability to trade logically—when disgusted, they want to get rid of what they hold more quickly and when sad, they lose ambition.

“Emotions affect the valuation of an asset. We know this, but death, divorce or even a negative headline can also change a client’s most basic desires and abilities,” says Dr. Lisa Kramer, an expert on behavioural finance, speaking at the Exchange Traded Forum 2012.

She adds, “On an evolutionary level, overconfidence and overvaluation is a positive because it caused people like Columbus to discover land due to his confidence in his abilities. Clients, however, shouldn’t look to outperform the market or make history. By doing so, they [overvalue their investing abilities] and hurt their bottom line.”

In another example, Kramer revealed the limitations of our capacity to adapt to unexpected change. As an example, she showed an infamous video demonstrating the psychological process of selective attention (click to view the video on YouTube). The audience was surprised to learn how people tend to focus only on the task at hand and don’t notice even major changes.

“Our biases and limited capabilities make us miss unexpected changes while involved performing involved tasks,” says Kramer. “As investors, we make complex, high-stakes decisions all the time and believe we have all mental faculties at 100%. The reality is that we don’t.”

Since the forum was focused on ETFs, Kramer identified the two most dangerous neurological ticks when considering the new products. With the number of ETFs in Canada growing rapidly, she pointed out that too much choice can be bad for your client.

At a neurological level, people can only handle so much information. So, while there are 250 products available in Canada, it’s worth choosing only a handful that you think your clients could benefit from. If you present 8-10 at once, she says you will confuse 5% of your clients; if you present more, that number will triple.

To combat this confusion and information overload, she suggests choosing 3-5 products that match your clients’ portfolios. This way, your clients will avoid mistakes like giving up and “leaving a lot of money on the table rather than optimizing. With too many choices, they may also allocate poorly by splitting into as many options as you offer. They trust you, so use sequential presentation and provide good, diverse suggestions.”

Earlier in the week at a CFA seminar titled The Faces of Behavioural Finance, Arnold S. Wood confirmed the same problem. He also introduced neurofinance and the fact that people can only fully consider three choices at once. “People have limited information processing and calculation ability. After even 3 simple calculations, we can become confused. So, how can we compute 60 complex stocks?”

He adds, “We satisfy ourselves with what we’re able to store and compute, and we don’t often optimize.”

Additionally, Kramer says all people compartmentalize data and often have different mental accounts for different income sources. For instance, people may use their annual bonus for their yearly vacation. If you suggest using it in a more optimal way like reducing debt, they may say that’s not possible because it’s already allocated. When looking at new products like ETFs and suggesting that clients review their portfolio, make sure to consider this mental roadblock.

“Clients and their advisors need to consider portfolios as a whole rather than in pieces,” says Kramer. “A broader view may reveal the need to reallocate, look at different vehicles or optimize more effectively in order to fully serve your clients’ needs and priorities.”

One important question is: should you explain these mental shortcomings to your clients? Kramer says “definitely, yes. These are built in tendencies and clients should be aware of their biases. You should encourage sensible behaviour by helping them take these behaviours into account.”

Wood also stressed, “Money managers also have fatal attractions that conflict with their cognitive processing. We are all coded with biases and beliefs, and these codes are hard to break.”