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Jul 2, 2019

What If Advisors Are Biased?

by John DeGoey

John De GoeyAlthough it has taken a bit too long, behavioural economics is finally entering the mainstream. Daniel Kahneman won the Nobel Prize in Economics in 2002 for his ground-breaking work done over the previous decades with his research partner, Amos Tversky. He shared the Nobel with Vernon Smith. The research done by the early behaviouralists shows how people predictably and repeatedly use quick, easy and often incorrect mental shortcuts when making decisions.

Over the past generation, many of the world’s leading economic thinkers have validated this earlier work and the field of behavioural economics has grown to become a widely accepted consideration among thoughtful investors.   In October of 2017, Richard Thaler of the University of Chicago won yet another Nobel Prize for the behaviouralist camp. Perhaps the greatest challenge coming from the behaviouralists is the very premise of traditional economics. The whole idea of economic optimization (production methods, supply and demand, profit maximization) was turned on its head.

The idea of supposedly rational people engaging in unambiguously irrational behaviour is one of the marvels of humanity. We all do it, although few of us would admit as much. Kahneman, for instance, acknowledges that he is biased. If someone as self-aware and familiar with all of life’s biases can acknowledge that he has bias, what reasonable chance do the rest of us have? More to the point, if someone in such a strong position to notice bias and weed it out does not feel he can do it competently, shouldn’t everyone acknowledge the fruitlessness of the endeavour?

It seems one of the best ways for people to combat the various behavioural quirks we all have is to read about the disparate shapes and forms that bias might take, and then do a thorough inventory of our own decision-making. Do we engage in compartmentalization or mental accounting? Are we over-confident? Does loss-aversion cause us to hold on to money-losing propositions for longer than we otherwise might?

These self-assessment questions are an important part of what’s needed. If you can’t step back and disassociate yourself (and what you personally want to be true) from the deeper considerations at play, you’re probably doomed to fail. While that statement is true for pretty much everyone, there’s a specific sub-set of society that I think needs to pay close attention: financial advisors. People come to advisors for insight, perspective and guidance as they try to navigate life’s biggest financial decisions. The presumption is that advisors won’t be prone to many of the most egregious gaffes made by ordinary retail investors. However, since everyone is susceptible to bias, the question that it begs is: “What if my advisor is as biased as I am or—heaven forbid—even more biased”? The impression I get is that most people—and most advisors—seldom stop to contemplate that.

In my new book, Stand Up to the Financial Services Industry, many advisor biases are explored. Many of them are unwitting and well-intended. Of course, giving bad advice with good intentions is a major problem. What matters is the veracity of the advice, not the purity of the intent. Evidence has recently been released that shows many advisors are prone to doing some truly illogical and harmful things. Among other things, they run concentrated portfolios, chase past performance and pay too little attention to product costs. Two of these tendencies can be combined into one behaviour: favouring actively managed mutual funds over cheaper products that feature either passive or factor-based approaches.

While there are always exceptions, the concern investors ought to have is regarding the appropriateness of advice that is based on improbable outcomes. Obviously, nothing is completely certain, but based on a balance of probabilities, a clear picture of what an investor might reasonably expect can be drawn. Ask yourself some probing questions:

  • How do I make decisions?
  • What is the probability of success? (note that what is left over is the probability of failure)
  • What’s at stake?
  • How much is gained if I am right?
  • How much is lost if I am wrong?

Let’s compare two separate examples to illustrate the variance of possible rationales and the variance of possible outcomes. The first is buying a $5 lottery ticket every week for the rest of your life. The second is investing $100,000 in a basket of six actively managed mutual funds as opposed to a basket of six passive Exchange traded Funds (ETFs) (in the identical asset classes) for the rest of your life. In both cases, assume the person is 40 and lives to be 90.

Now, I’m just spit-balling here. I don’t know what the odds are for various possible outcomes in a world where very little is certain. I’ll try to be fair in depicting the choices and then I’ll ask if we can draw conclusions form what we see.

First up is the lottery. It represents $5 invested every week for 50 years:

  • Probability of success: Let’s say the odds of success are one in ten million. That’s 2,600 tries where the odds are one in ten million each time.
  • What’s at stake: That’s 5 X 52 X 50 = $13,000.
  • Gained if right: let’s say $1,000,000 (note that you could theoretically win more than once).
  • Lost if wrong: up to $13,000.

So, the decision here is one of risking a little for a highly improbable opportunity to make a lot. On one hand, you’re almost certain to fail. On the other, you’re almost certain not to miss the $13,000 you spent over the course of your adult lifetime trying to win.

Next up, the second option: spending (let’s say) 1% a year more in product costs every year for 50 years expecting that it will pay off in the form of higher returns than would otherwise be the case as compared to cheaper options with an otherwise identical mandate.

  • Probability of success:

Different experts draw the line in different places, but most reasonable people would suggest that a basket of six actively managed products beating a similar basket of products that is 1% cheaper over a 50-year time horizon is charitably about 1%.

  • What’s at stake:

Approximately 1% of $100,000 compounded over 50 years. Let’s assume that the product that costs 1% more returns 1% less because of that cost differential. Specifically, let’s say the blended benchmark portfolio would have returned 7.2%, but that the cheap alternative cost 0.2% and the expensive alternative cost 1.2%. This cost differential will leave investors with the difference in growth between 6% and 7% - net of fees. Growing at 6%, that initial investment turns into a tidy $1,742,015. Meanwhile, if the growth had been 7%, we’d be at an astonishing $2,845,702. The difference is $1,103,687. That is what is at stake, assuming everything else is the same. Of course, everything else is not the same. One obvious difference is that the actively managed option will incur more trading activity (say 50% turnover as compared to 5%), so that the annual tax liability will be higher. Both portfolios will grow by less because of taxes, but the expensive option will see a larger leakage than the stingy option.

  • Gained if right:

Some dollar amount above the alternative, which is likely to be modest.

  • Lost if wrong:

About $1.1 million, give or take. Think of it in terms of a normal distribution (bell curve). The best guess is a relative loss (opportunity cost) of $1.1M. Some people will only be out $500,000. Others might be out $1.5M. Only the extremely lucky (the approximately 1% on the end of the right tail of the distribution) will come out ahead.

The observation here is that advisors seem to be making consistently sub-optimal recommendations where the odds of success are remote and the cost of the associated failure substantial. The decision to recommend expensive products is the mirror image of recommending that clients buy lottery tickets. The lottery plan involves a relatively modest outlay and a modest likelihood of success, albeit ion spectacular terms. The decision to use high cost products is highly likely to produce a worse result—full stop.

It seems many financial advisors are insufficiently self-aware to recognize the substantial harm that is likely to be caused because of having beliefs systems that can be called ‘misguided’. In speaking with advisors from across the country, I remain amazed that so many of them cling to the use of expensive products. The viewpoint that expensive management is “worth it” is almost always suboptimal when using a moderate cost differential combined with multiple asset classes and a long time horizon. It seems the only people who don’t recognize that are financial advisors.

John J. De Goey, CIM, CFP, FELLOW OF FPSC is a registrant with Wellington-Altus Private Wealth Inc. (WAPW). WAPW is a member of the Canadian Investor Protection Fund (CIPF) and the Investment Industry Regulatory Organization of Canada (IIROC). The opinions expressed herein are those of the author alone and do not necessarily reflect those of WAPW, CIPF or IIROC. Investors should seek professional financial advice regarding the appropriateness of investing in any investment strategy or security and no financial decisions should be made solely on the basis of the information and opinions contained herein. The information and opinions contained herein are subject to change without notice.

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