Prasad Ramani, CFA, runs Syntoniq, a B2B tech firm that helps advisers gauge investors behavioral biases and blind spots. Syntoniq, which currently operates in United States and Canada is set to launch in India. Ramani talks to Morningstar about the biases investors face and how advisers can help overcome them.
What common biases investors tend to face and how can they overcome them?
Before we talk about biases, we should understand the overall decision-making framework first. There are three key steps: first, investors form beliefs, these beliefs lead to decisions, and decisions lead to actions. The first two steps of belief-formation and decision-making are influenced by mental shortcuts that often take place below the level of our conscious awareness.
These mental shortcuts are important as they help our brains conserve precious energy to make efficient decisions. For example, from an evolutionary perspective, imagine your ancestors were faced with a lion when hunting. If they had to perform mental calculations about the speed of the lion, it’s acceleration, the angle at which it may jump, etc. you probably wouldn’t be here. In a modern-day context, if your wardrobe has about 15-20 pieces of clothing, there are potentially thousands of combinations for you to consider. However, your brain is very efficient and takes shortcuts to arrive at what to wear.
While these mental shortcuts are very useful for daily life, they can become a problem when we go about using them in an auto-pilot mode, especially in a different context like investing. Thus, unexamined shortcuts can turn into biases which can have both positive and negative effects on our investment decision making. Obviously, for an investor, negative influences are generally more critical as they can lead to very costly mistakes.
Based on our research, we found that out of a host of behavioral biases, three are extremely critical, we call them the foundational biases that directly impact an investor’s financial decision-making: Overconfidence, Anchoring, and Representativeness.
The key to overcoming these biases is to develop self-awareness about them so they can be identified and corrective steps can then be taken to de-bias our decision-making process.
How can advisers coach their clients to stay calm and focus on their goals in the current market situation?
When faced with extreme uncertainty or stress, human mind tends to act in two different ways: either completely shut off and do nothing or jump to taking quick action. Unfortunately, both these natural tendencies are not backed by calm and clear thinking.
A first step to take when faced with such market conditions is to focus on our long-term goals. Trying to time the market to avoid a loss or make a quick gain in the short term is a game we just cannot win consistently over time. It is at such times that we need to consider our long-term goals and carefully evaluate where we stand with respect to achieving them.
We also need to understand that our desire to act is often driven by our changing risk appetite. When markets are rallying, investors tend to have a very aggressive risk appetite, but once markets start crashing, it starts to reduce dramatically. So, having a clear understanding of what risk means to us can help us clarify why we feel like acting in a certain way. It is also important to realize that risk is not a single, unchangeable metric, but it is a dynamic range that is influenced by our biases, behaviors and blind spots.
So, having a clear understanding of who we are and why we think the way we think is extremely important for investors to remain calm during these types of surreal market conditions. And this is why it is extremely important for advisers to become familiar with the world of behavioral finance so they can behaviorally coach their clients into making the right decisions. Many research studies have shown that this is a great way for advisers to generate positive ‘behavioral’ alpha for their clients that is more sustainable than the typical index-beating alpha.
Like investors, studies show that advisers too tend to have their own biases. Can you throw light on what kind of biases advisers face and how can they overcome them?
Oh yeah, absolutely, advisers also tend to exhibit biases like anyone else. For example, advisers tend to show high overconfidence especially because of their expertise. They also tend to get swayed by the ‘illusion of control’; when you are an expert, you can come under the illusion that you can control the outcome more than an average person.
More crucially, behavioral finance is not just about biases and behaviors. It can also help advisers reframe the services they provide to their clients. Instead of focusing on beating the market, their value-add can be reframed as helping clients achieve their long-term financial goals. Using behavioral finance principles also helps advisers stand apart in a crowded, look-alike marketplace, significantly increasing business revenue through greater client retention and referral generation.
Clients risk appetite or how they perceive risk could change from time to time. Studies suggest that investors don’t take rational decisions. In such a scenario, how does Syntoniq help understand client psyche?
We at Syntoniq tend to think of so-called investor irrationality as ‘normal’ human behavior. By focusing too much on ‘rationality’, there is this assumption that we can somehow turn into cold, calculating robots especially when it comes to investing. Emotions are what make us humans in the first place, so, instead of trying to filter them out of the investment decision-making process, it is better to work with them so we can make better financial decisions. Does that make sense?
And yes, you are spot on! Risk appetite changes from time to time, and this is something even most experienced advisers struggle with. This is because what you state as your risk appetite is actually different from what you actually do when market reality hits you. We call this the difference between ‘stated’ risk and ‘revealed’ risk. This is because our attitude to risk is shaped by many factors. For example, let’s assume you had a recent run of successes in your professional career, you will see that your investment risk appetite has also started to increase. If you are happy, your risk appetite tends to go up and the opposite happens when you are sad. Your risk appetite is also shaped by how you think about your current financial condition and how strongly you feel connected to the future.
At Syntoniq, we view risk through a behavioral lens which is why we have both a Standard Risk Score and also a range around it called the Dynamic Behavioral Risk Range. For example, both you and I may have the same Standard Risk Score of 70, but your range may be 50 to 70, while mine may be 70 to 90. This means, while you are likely to reduce risk going forward, I am very likely to increase it. We calculate this range based on responses to our 10-minute my3B behavioral assessment which measures seven key investor traits: Overconfidence, Representativeness, Anchoring, Future Orientation, Loss Aversion, Situational Belief, and Financial Mastery.
While advisers tend to use a number of different tools, our my3B behavioral assessment is unique to the market where it is designed to help clients understand themselves and their decisions better. While this is very important even during normal market conditions, it becomes all the more crucial during stressed conditions.
Today, investors can see their portfolios on the go. This helps them take action (redeem) on the spur of the moment. In this age of technology and information overload, how can advisers teach their clients to sift information relevant to them from the noise?
We live in uncertain times. Claude Shannon, the father of mid-20th century information theory, once famously stated that “information is the resolution of uncertainty”. Many of us living in 2020, at the height of the information age, might disagree. While we have largely adapted to—and are benefitting from—life in a fast-moving, data-rich and interconnected world, its resulting complexity has not done away with uncertainty. It has only increased it.
Helping sift through information from noise is what differentiates a great adviser from a good one. One way to do that is to help clients understand how they process data to begin with; this basically leads to the first thing I mentioned, the three key steps to making decisions. To be able to do this, advisers need to be armed with the psychology behind investment decision-making, which is what behavioral finance is all about. We cannot control the external environment, but we can certainly control how we react to it.
I think a quote from Shantideva, a renowned Indian Buddhist Scholar makes perfect sense in this context; Shantideva wrote:
“Where would I find enough leather
To cover the entire surface of the earth?
But with leather soles beneath my feet,
It’s as if the whole world has been covered.”
The leather shoes for advisers and their clients are behavioral tools to help them get better at making investment decisions, instead of worrying about the information overload out there.