Mistakes that Foil Great Advisors

Humans instinctively rely on heuristics or biases to make decisions, which allows irrational minds to overwhelm rational thought processes. As financial advisors, we’re prone to some of the same mistakes. Here’s how a better understanding can help you protect your business.

Simple and Familiar Versus Complex and Unfamiliar

Our brains are complex organs capable of many processes. But sometimes, the brain is faced with many options, becomes overwhelmed and activates heuristics—mental shortcuts that can produce imperfect answers to complex problems.

Think about the last time you went to the store and saw 15 types of pasta. How did you choose? Did you buy what you always buy—the simple and familiar solution? Or did you go through a complicated analysis that factored in price per pound, ingredients, nutrition and other inputs?

As advisors, we juggle a myriad of tasks on a daily, sometimes even hourly, basis. When we’re busy responding to clients, fulfilling firm or legal requirements, and staying updated on markets, it’s hard to fully investigate a new fund or service.

Getting detailed information about a variety of options and deciding based on a thoughtful, comparative analysis require what Daniel Kahneman, a leader in the field of behavioral science, calls broad framing. In his 2011 book, Thinking, Fast and Slow, Kahneman shows that broad framing “will be superior...in every case in which several decisions are to be contemplated together.”

If point A is cheap and familiar (our go-to pasta is on sale), we’re unlikely to buy the new locally sourced gourmet brand that’s unfamiliar and pricier (Display). Point A makes more emotional sense than point B. It’s complicated to know what’s best, so our brains prefer to answer a simpler question. We lock in the decision, find confirmation to support it, and move on, feeling good about the choice. In investing, there may be nothing intrinsically better about a cheaper, simpler or more familiar investment. Those characteristics don’t always lead to the best investments (based on goals, risk and expected return).

It isn’t easy to interrupt our natural tendency to use heuristics, but it can be done. According to Kahneman in Thinking, Fast and Slow, “Decision makers who are prone to narrow framing...would do better by having a risk policy that they routinely apply whenever a relevant problem arises.”

Proper Decision Weighting Prevents Procrastination

Sometimes it can be challenging to make any decision at all.

One way our brain determines when to act is by weighing the need to decide. If the problem (such as new transparency rules surrounding fee disclosure) seems far off or unlikely to happen, the brain gives it less weighting, procrastinates and focuses on more immediate concerns. As the problem moves closer, the brain assigns a higher weighting, shifts gears and stimulates activity. It’s like crossing a threshold; when the disruption gets too close for comfort, the brain signals an urgent need to act.

Kahneman’s research reveals that the human brain is poor at making decisions about events that may not happen. This explains why many advisors prefer to wait, hoping that the new MSRB regulations will be reversed: their brains haven’t yet crossed the threshold that demands action. The industry has been discussing the lack of pricing transparency for years, but until recently, no concrete action had been taken. Because certainty about the future was low, the motivation to act remained low, too.

The prudent advisor takes a better approach, shifting the focus away from the question “How likely is it that the new regulations will be passed?” and instead considers, “How much will these regulations impact my relationships if they pass?” By answering this second question, one that’s more within his purview, an advisor can attach a more appropriate weight to the importance of acting sooner rather than later.

So, our advice is to act now. By understanding how heuristics can affect your decision-making, and by putting steps in place to avoid shortcuts and emotional choices, you can protect your business from whatever the future holds.