By Keith Redhead
Keith Redhead is principal lecturer in finance at Coventry
University in the United Kingdom. He has published nine books
including, Personal Finance and Investments: A Behavioural Finance
Perspective (Routledge, 2008). He teaches courses on behavioral
finance, financial services, and institutional
The paper provides a guide to the implications of behavioral
finance for financial advisers. The focus is on the process of
financial decision-making. Financial decision-making is seen to be
subject to behavioral biases at three stages:
- The perception of information. There is a
difference between objective information and perceived information.
Decisions are based on perceived information. Selectivity,
interpretation and closure affect perceptions. These processes are
affected by behavioral biases, such as narrow framing and the
availability bias along with a wide range of motivational,
attitudinal, social, and emotional factors.
- Cognition. Thought is not entirely rational
and is influenced by bounded rationality, the extent of cognitive
reflection, mental accounting, illusions and self-deception along
with other cognitive, emotional and social factors.
- Motivation. Decisions may be made but not
implemented. Procrastination and mistrust can inhibit the
activation of decisions.
A behavioral finance view of the financial decision-making
process is depicted by Figure 1.
|Historical prices/Public information/Private Information/Noise
|Information overload could terminate the process
Satisficing subject to heuristic simplification, self-deception,
social influences, emotion and mood
There is a distinction between objective information and
perceived information (objective reality and perceived reality).
What people perceive is influenced by how they select information
to process. People are incapable of absorbing all information, and
are therefore selective as to what information receives their
conscious attention. The process of selection may occur largely at
an unconscious level. They need to distinguish between reliable
information and noise; and to select the most important pieces of
reliable information. Noise is irrelevant or inaccurate
information, such as misleading rumours.
Each person will interpret information differently. Their
interpretations of information are influenced by their motives,
their knowledge, their experience, their feelings, and by a
multitude of other cognitive, emotional, and social influences.
There is also a closure process. Where information is
incomplete, people tend to fill the gaps in order to obtain a
complete story. Additional "information" is used to supplement what
is perceived in order to obtain closure. Some information may be
disregarded if it is inconsistent with the perceived "story." The
factors that influence closure are similar to those that influence
the interpretation of information. What one person sees can be very
different to what another person sees, even though the objective
information is the same (Litterer 1965; Ricciardi 2008).
Decisions are made on the basis of perceived information. A
financial adviser should be alert to the possibility that a client
has inaccurate perceptions, which may need to be challenged.
DiFonzo and Bordia (1997) showed that rumours affect investment
decisions, even when the rumours come from sources that lack
credibility. There is evidence that people make decisions based on
stories constructed around information, rather than on the
information itself (Mulligan and Hastie, 2005). If a rumour is
consistent with such a story or provides a story (an explanation of
events), it may be more readily believed. People are prone to
accept information from unreliable sources if such information is
believable and consistent with their existing perceptions of events
(Evans and Curtis-Holmes, 2005).
There are cognitive biases that can cause an exaggerated
perception of risk. Narrow framing entails focus on short-term
investment performance when the investment is long-term. An example
is the person who is concerned about quarterly pension fund returns
when retirement is 30 years in the future. Short investment
horizons are much more likely to show losses than long horizons. A
short-term focus can cause an exaggerated view of the probability
of losses, and hence an increased reluctance to contribute to a
Diacon and Hasseldine (2007) found that clients were more likely
to invest when shown presentations of performance over long periods
than when they were presented with a succession of short-period
returns. Although more information is frequently thought to be
beneficial, a financial adviser might benefit a client by making
performance information infrequent.
The availability bias can also produce an exaggerated perception
of risk. When making decisions, people tend to be influenced by
what can be readily remembered. Vivid, much-publicized events are
easily recalled. Stock market crashes are vivid, highly publicized
events. Long periods of steady market advance are less vivid and
less publicized. The result is that people over-emphasize crashes
and exaggerate risk. An adviser can provide more balanced
information in order to overcome negative perceptions arising from
the availability bias.
Ciccotello (2009) provided anecdotal evidence that illustrates
the availability bias. It is based on graduate students studying a
personal financial planning course. He compared the attitudes of a
1999 cohort of students with those of a 2003 cohort, suggesting to
both cohorts that financial plans should be based on the long-term
average stock market returns of 8 to 10 percent a year.
In 1999, stock markets had experienced four consecutive years of
strong performance. The students tended to reject the recommended 8
to 10 percent and chose 20 to 25 percent a year instead. The 2003
cohort of students had witnessed large market falls in each of the
previous three years, and those students were reluctant to use any
positive market rate of return. Both groups of students had
expectations of stock market returns, which were heavily influenced
by recent experience. This indicates that an adviser should provide
evidence of long-term stock market returns. However the emotional
impact of recent experience cannot be easily removed.
Effects of Information on Perception
A number of studies have indicated that attitude to stock market
risk depends upon the recent behaviour of the stock market (Clarke
and Statman 1998; Shefrin 2000; MacKillop 2003; Grable, Lytton and
O'Neill 2004; Yao, Hanna and Lindamood 2004).
An alternative perspective on that evidence can be derived from
research by Weber and Milliman (1997) who suggested that risk
preference may be stable and that the effect of situational
factors, such as stock market performance, may be caused by changes
in perceptions of risk. They found that influences on investment
choices simultaneously affected risk perceptions. It could be the
case that attitude to perceived risk is constant, and that
what changes is the perception of risk. From the perspective of
providing financial advice, this implies that by correcting
misperceptions about the risks of investments, a financial adviser
can have a positive influence on investment decisions.
There are factors that reduce perceived risk. There is a
tendency for information- even irrelevant information-to reduce
perceived risk. This has been called the illusion of information.
Information can be over-interpreted. The representativeness bias
leads people to see patterns in random events or random numbers.
Whereas the objective information is a series of random price
changes, an investor may perceive a pattern in the changes. The
perception of a pattern could result in a forecast when no forecast
is warranted. In consequence, the degree of risk is
under-estimated. A financial adviser might note that the provision
of some information about an investment is likely to reduce a
client's perception of risk. However the provision of too much
information could cause confusion and procrastination. Information
overload inhibits decision-making. Also, the familiarity bias
suggests that information that is not understood is likely to deter
a client. People are reluctant to buy products that are unfamiliar
Among non-experts, risk is perceived as greater if the person
lacks information about, or control over, outcomes. Lack of
information and control in regard to investment outcomes leads to
mistrust of providers of financial services and mistrust of
financial advisers (Sjoberg, 2001). The mistrust of financial
advisers may be based on a perceived affiliation bias whereby
advisers are seen as being too trusting of the providers of
Some information is predominantly in the mind of the investor.
The information has little objective basis and is nearly entirely
perceived. This includes future income prospects. Bolhuis and
Goodman (2005) cited Laibson as suggesting the possibility of
unbounded optimism. This includes optimism about future income. If
a client expects a substantial rise in income, that perception of
future income may be used as a reason for not saving in the
present. The client chooses to delay saving until the expected
future income is received. In the absence of the expected increase
in income, saving never takes place.
Behavioral finance takes a different view of information
processing to the view taken by traditional finance. Rather than
seeing people as optimizing, it sees them as satisficing (Simon
1955, 1956; March and Simon 1958). Satisficing arises from bounded
rationality, which is the limited rationality that is present
because people do not have the requisite intellectual capacity for
fully rational behaviour. When satisficing, a person looks at
alternatives and chooses the first one that is acceptable (or the
best from a restricted set of alternatives). March and Simon
described an alternative as optimal if it is possible to compare
all the alternatives and one is preferred to all the others.
Discovering all the alternatives may be too time consuming, or may
even be impossible. In consequence, a person would simply find an
alternative that satisfies their criteria of acceptability.
Satisficing is subject to a number of behavioral influences such
as self-deception, heuristic simplification, social influence,
emotion and mood (see Redhead 2008 for an overview of behavioral
influences). Rationality is reduced by both limited intellectual
capacity and various psychological biases that affect cognitive
The departure from full rationality increases as the complexity
of decisions increases. It also increases as the time available for
decision-making is reduced. Time constraints reduce the ability to
think about a decision and further intensify the bounds on
rationality. A person facing complex decisions and time constraints
experiences extremely bounded rationality. There would be a
corresponding increased reliance on heuristic simplification (rules
of thumb that replace rational thought). One implication is that
the effects of psychological biases can be reduced by allowing the
client a substantial amount of time for making financial decisions
and by ensuring that the client is not presented with the need to
make a complex decision.
Frederick (2005) presented evidence that the accuracy of the
perception of risk is related to a personality characteristic
referred to as "cognitive reflection." Cognitive reflection is the
ability to resist the first impulse or intuition. It is the
tendency to reflect and think about a problem rather than following
initial inclinations. Low cognitive reflection is associated with a
tendency to yield to immediate impulses by making quick decisions
with little thought and deliberation. People who are high in
cognitive reflection tend to be good at evaluating risky investment
situations, and tend to be willing to take risks.
Nofsinger and Varma (2007) cited evidence that suggests a link
between cognitive reflection and relative immunity from behavioural
biases. They also carried out a survey, which found that
professional financial advisers (personal financial planners) were
above average in terms of cognitive reflection. Frederick had
presented evidence that suggests a link between hyperbolic
discounting (i.e. overemphasis on the present) and low cognitive
reflection. Nofsinger and Varma provided evidence to support that
People with low cognitive reflection fail to see the interest
rate implicit in a choice between two different sums of money at
different points of time (the present and a future date). Personal
financial advisers should be able to see the implicit interest
rates in order to provide good advice to their clients. More
generally, clients with low cognitive reflection are more in need
of guidance since their ability to understand alternatives and to
choose between them would tend to be relatively low.
Among the psychological biases that affect investors are choice
bracketing and mental accounting. In both cases, the problem is a
failure to take a coherent view of the whole financial
Choice bracketing causes people to evaluate each new investment
independently of the existing portfolio. The result can be a poorly
diversified portfolio. Although each individual decision may seem
good in isolation, the aggregation of the individual decisions may
represent a poor portfolio.
Mental accounting may cause incoherence in personal financial
management since it can lead to financial decisions being taken
independently of each other (Kahneman and Tversky 1982). If a
person separates money holdings according to their uses, or
sources, financial organization can lose coherence. The separation
of finances may be into distinct bank or investment accounts, or
may simply be in the mind of the individual. Although mental
accounting can help in the organization of finances, it can also
hinder rational decision-making.
For example, someone who makes an investment whilst having a
debt is effectively financing the investment with borrowed money.
If the person did not separate the debt and investment into
separate mental accounts, the decision may have been to reduce the
debt rather than buy the investment. A financial adviser would
provide a useful service by pointing out the inter-related nature
of a client's finances. One dimension of the provision of financial
advice is teaching the client about personal financial
Mental accounting can result in different investments being
allocated to different purposes. For example, one portfolio may be
for the purpose of funding retirement whilst another is for
financing children through university. Mental accounting keeps
these two portfolios separate so that neither is subsidized by the
other. It may be that in aggregate, the two portfolios are showing
strong gains whilst one is showing a loss. The mental accounting
will cause the perception of loss, in relation to a portfolio,
despite the overall profit.
One frequent rule for self-control is "never touch the capital."
This means that dividends and interest-but not the capital
sum-should be used to finance spending. A low dividend may lead to
a forced withdrawal of capital. There may have been a strong
capital appreciation, but the mental accounting that separates
capital and dividends could result in feelings of failure and loss.
An adviser could point out that capital appreciation is an
acceptable alternative to dividends as a source of financing
consumption spending, and that realizing part of a capital gain
need not jeopardize future income.
People may not realize that they are using mental accounting,
but mental accounting determines how a person thinks about finance
and makes financial decisions. People have widely differing systems
of mental accounting. An adviser should be wary of thinking that a
client has a conventional view of money and financial decisions. A
person's mental accounting may cause unusual ways of thinking
about, categorizing, and evaluating money. If financial advice is
inconsistent with a client's mental accounting, the client may
choose not to accept the advice (McGuigan and Eisner, 2003).
Illusions and Deceptions
Another cognitive bias is the illusion of control. The illusion
of control causes people to behave as if they were able to exert
control where this is impossible or unlikely; such control includes
the ability to identify future out-performers. The illusion of
control, together with overconfidence, may explain why so many
investors choose actively managed funds when tracker funds
outperform them and have lower charges.
A study by the Financial Services Authority in the U.K. (Rhodes
2000) confirmed the findings of academic studies, which found that
the relative past performance of actively managed funds is no
indicator of future relative performance (not everyone is
convinced, see Redhead 2008). It may be that overconfidence in
their own selection abilities, and the illusion of control provided
by the facility of choosing between funds, cause investors (or
their financial advisers) to select actively managed funds when
tracker funds offer better potential value.
According to Langer (1975), people often find it difficult to
accept that outcomes may be random. Langer distinguishes between
chance events and skill events. Skill events entail a causal link
between behaviour and the outcome. In the case of chance events,
the outcome is random. People often see chance events as skill
events. When faced with randomness, people frequently behave as if
the event were controllable (or predictable). If people engage in
skill behaviour, such as making choices, their belief in the
controllability of a random event appears to become stronger. There
is considerable evidence that investment managers are unable to
consistently out-perform stock markets. This suggests that the
outcome of investment management is random. However, since the
investment managers engage in skill behaviour, analysis and choice,
they tend to see portfolio performance as controllable. Retail
investors and financial advisers are also likely to see the
performance of their investment choices as controllable; the act of
choosing enhances the illusion of control.
Overconfidence is commonplace. Investors can be overconfident
about their forecasts and opinions. Overconfidence can be
reinforced by the hindsight bias. Hindsight bias causes people to
believe that past events were capable of having been forecast (even
when they were not possible to forecast). In consequence, clients
may question why their financial advisers failed to forecast the
Overconfidence and the illusion of control can be reinforced by
confirmation bias. Confirmation bias is a tendency to interpret
information as confirming a preferred point of view and an
inclination to seek information that confirms the opinion whilst
discounting contradictory information. An adviser could attempt to
combat overconfidence and confirmation bias by asking the client to
consider both the opposite point of view and the consequences of
being wrong (Moisand 2000).
A person may make a decision but not act on it. Some motivation
is required for action. Behavioral finance has identified the
presence of procrastination and inhibition in the activation stage
of investment decisions. Even when decisions have been made they
will not be implemented unless the positive motivation is strong
enough to overcome inclinations and feelings that inhibit action
(Neukam and Hershey, 2003).
The status quo bias and conservatism tend to inhibit action by
predisposing the investor against change. The status quo bias is
the inclination to retain an existing investment in preference to
switching to a new one. Possession of something tends to enhance
its perceived value. Conservatism is reluctance to change an
opinion. Fear of change, and fear of the process of change, can
prevent action. This is particularly so if there is uncertainty
about the costs and benefits of a decision. Confirmation bias can
produce an over emphasis on the case against change.
One aspect of prospect theory is the relative weighting of gains
and losses. Typically, losses are emotionally weighted more
than twice as much as gains of equal size. This is referred to as
loss aversion. So if there were a 50 percent probability of gain
and a 50 percent probability of loss, an investment would not be
made. Loss aversion inclines people to inaction rather than
Financial activation motivates saving for retirement, whereas
financial inhibition discourages saving. Financial activation is
goal-based, and financial inhibition is fear-based. They are two
distinct characteristics rather than two ends of the same
Neukam and Hershey found that that the people who saved most
were those with the strongest financial goals and the lowest level
of fear. In relation to retirement saving, visions of old age are
likely to affect financial goals. A vision of prospective poverty
might strengthen the goals of saving as might visions of a
leisure-orientated lifestyle in retirement. Conversely, images of
poor health and fading looks in old age could produce inhibition
since people might put old age out of their minds. If they do not
think about the retirement years, they may not save for them. The
goals and fears were not only related to visions of old age, but
also to the planning process. The personal characteristics
For example, a strong drive toward saving (planning) for
retirement could be offset by a high level of fear about the
planning process; a strong desire to accumulate wealth for
retirement could be offset by a fear of stock market risk or a
distrust of the financial services industry. This latter point is
close to the Harrison, Waite and White (2006) observation that
mistrust of financial advisers can deter retirement saving. The
importance of fears concerning the saving (retirement planning)
process relates to the Jacobs-Lawson and Hershey (2005) findings
that financial knowledge and risk tolerance are positively related
to retirement saving.
Many people exhibit a strong emphasis on the present. Receipt of
$50 immediately may be preferred to $100 next month, whereas $50
next month would not be preferred to $100 in two months. This
inclination toward gratification in the present is seen to arise
from a lack of future time perspective (Jacobs-Lawson and Hershey
2005) or from hyperbolic discounting (Ainslie 1991).
Benartzi and Thaler (2004) used the principles of behavioral
finance to develop a practical program for increasing the level of
saving into pension schemes. The program is called Save More
Tomorrow (SMarT). It was designed to help employees who want to
save more for retirement but find that their willpower is
One feature of SMarT is that there is a time lag between
commitment to the scheme and the date on which payments begin. This
overcomes the problem that people tend to value immediate money
very highly. People find it easier to commit to a future investment
than an immediate one.
A second feature is that increases in payments to the scheme
coincide with pay rises. By using part of a pay rise, contributors
do not feel that they are reducing their disposable income
(take-home pay). This avoids the aversion to loss identified by
prospect theory. It does not seem to matter whether the pay rise is
a real one, or simply matches inflation, since people seem to
suffer from money illusion. The real rise is the increase in the
purchasing power of the wage; if prices are rising, the real rise
is less than the rise in money terms. Money illusion causes people
to see money rises as real ones. Evidence for money illusion has
been found by Kahneman, Knetch and Thaler (1986) and by Shafir,
Diamond and Tversky (1997).
A third feature is that the contributions to the pension scheme
increase every time there is a pay rise, until a predetermined
maximum proportion of income is reached. The status quo bias
indicates that, when faced with a choice, people tend to do nothing
(i.e. they maintain the status quo). This causes procrastination.
If the decision has already been made to increase contributions to
the scheme, maintenance of the status quo entails proceeding with
the existing arrangement to increase contributions.
A fourth feature is that employees can opt out of the plan if
they wish to. This makes commitment to the scheme less binding, and
hence makes the commitment more likely. The status quo bias tends
to keep people in the scheme.
If action requires operating through an agent, there is
inhibition if the agent is not trusted. Such agents could include
financial advisers and financial organizations that provide
financial products for retail investors. Trust can be an important
factor in determining whether action is taken (Olsen 2008). For
example, a person may decide to start a pension plan. However if
that person does not trust financial advisers, the result could be
an absence of action.
Mistrust inhibits action. The lack of trust might relate to the
competence of financial advisers, or to the ability of advisers to
put clients' interests ahead of their own. Trust entails the
acceptance of vulnerability to the decisions of others. If the
investor cannot trust the competence or integrity of an adviser,
the pension plan will not be implemented. There also needs to be
trust in the organization that provides the pension plan. There
needs to be trust in regulators and in the markets in which the
underlying investments are made. Although an investor may wish to
invest in a pension plan, distrust of the stock and bond markets in
which the provider invests could deter the investor from pursuing
the pension plan. One of an adviser's tasks is to improve the
client's trust in the various agencies involved in the delivery and
provision of financial products.
Financial advisers paid by commission have a conflict of
interest. The products that are best for the client are not
necessarily those that pay the highest commission. It might be
argued that advisers should have sufficient integrity to consider
only the interests of their clients, but even the highest integrity
does not eliminate bias.
Research into the behaviour of auditors has indicated that the
psychological processes involved in conflicts of interest can occur
without any conscious intention to indulge in corruption (Moore,
Tetlock, Tanlu and Bazerman 2006). Confirmation bias, which entails
a focus on supporting information and rejection of opposing
information, is not a conscious process. Montier (2007) has
referred to the notion that people are able to exclude
self-interest in decision-making as the illusion of objectivity.
Biases from motivated reasoning are widespread; evidence exists for
their presence amongst medics and judges. The human mind is not a
disinterested computer; its operation is affected by moods,
emotions, motives, attitudes, and self-interest.
The inclination of financial advisers (and everyone else) to
consider their own interests is often referred to as the
self-serving bias. Most people try to be fair and objective, and
like to feel that others see them as acting fairly and objectively.
However, attempts to be fair and objective are undermined by
psychological factors of which people are unaware. The self-serving
bias inclines people (unconsciously) to gather information, process
information, and remember information in such a way as to satisfy
their self-interest. Evidence that supports self-interest may be
accepted without question, whilst contradictory evidence is closely
scrutinised (Koehler 1993). The self-serving bias, as other
behavioral biases, tends to be stronger in situations characterized
by complexity and uncertainty (Banaji, Bazerman and Chugh
A client will not trust an adviser unless the adviser is seen as
ethical. The perceived integrity of a financial adviser is
dependent upon the perceived ethical standards of the adviser.
Although good intentions are necessary for ethical behavior, they
are not sufficient. Cognitive limitations and biases, including the
self-serving bias, can lead to unethical behaviour even when the
intention is to be ethical. Many people accidentally blunder into
unethical behaviour (Prentice, 2007). A complicating issue is the
tendency for people to be overconfident about their ethical
standards. The self-enhancement bias not only leads people to
believe that they are above average in their abilities, but also
that they are above average in the maintenance of ethical standards
(Jennings 2005). If people are overconfident about their ethical
standards, they may be less inclined to critically examine their
behavior; "I am a good person, so what I do must be ethical."
Often people will rationalize unethical behaviour in order to
preserve a self-image of being ethical. Rationalization is
alternatively known as self-justification. Anand, Ashforth and
Joshi (2005) described some types of rationalization. They included
denial of responsibility; e.g. "It is not my choice, it is the way
the business operates," or "The client makes the final decision,"
or "The law allows it, so it is the fault of the government."
Another rationalization is denial of injury; e.g. "I know the
fund charges are high, but the good fund management will more than
There is denial of victim; e.g. "The client does not pay the
commission, the life assurance company pays it," or "Customers are
clever, they are not fooled."
There is appeal to higher loyalties; e.g. "I have a family to
Another form of rationalization is the metaphor of the ledger;
e.g. "The value of my advice is greater than the value of the
Colleagues and authority can undermine someone's ethical
standards without the person being aware of the process. There is a
conformity bias whereby people conform to the values and behaviors
of those around them, including colleagues. A person could
unconsciously adopt the unethical behavior of others. Obedience to
authority figures, such as employers and managers, can be a strong
tendency. Even when explicit instructions are not given they may be
inferred (Tetlock 1991). Strong emphasis on sales targets could be
taken as implying that sales volume is more important than other
factors such as business ethics.
The conformity bias can result in groupthink (Janis 1982, Sims
1992). Groupthink entails a uniformity of thought and values within
a group. In business settings, bonding activities such as awaydays
reinforce groupthink. If the thinking of the group were unethical,
a new member would tend to adopt the unethical thinking. The
concurrence of other group members in a set of values could lead to
the belief that those values are ethical. Risky shift is the
tendency for a group to take bigger risks than individuals within
the group (Coffee 1981). Group action dilutes an individual's
feelings of responsibility (Schneyer 1991). The increased risks
include increased ethical risks. Clients might be advised to make
A tendency to advise clients to take more risk than is
appropriate could be reinforced by the optimism bias. This can
manifest itself in an understatement of risk (Smits and Hoorens
2005) and an exaggeration of profit potential. The optimism
reflects genuinely held beliefs on the part of the financial
adviser. Corporate insiders may provide over-optimistic forecasts
because they really believe them, rather than because they intend
to deceive investors (Langevoort 1997). The same may be true of
investment analysts (Prentice 2007) and financial advisers.
MacCoun (2000) suggested that the chances of removing cognitive
biases from people's thinking are very low. One implication is that
regulation, to protect consumers from cognitively biased advisers,
is necessary. If regulation improves client trust, everyone could
benefit, but regulators must also be aware of behavioral
The principles of behavioral finance throw light on the
effectiveness of specific regulatory measures. For example, in the
U.K., financial advisers are required to tell clients how much
commission the advisers expect to receive. Laboratory studies have
indicated that clients follow the advice of advisers to nearly the
same extent as they would in the absence of knowing about the
conflict of interest. Also, advisers seem to feel less compelled to
be impartial when the conflict of interest has been revealed. The
presumed increased scepticism on the part of the client is seen as
reducing the need to be impartial (Bazerman and Malhotra 2005;
Cain, Loewenstein and Moore 2005).
Financial advisers would improve their service to clients if
they correct biases arising from the psychology of perception
(perceived information), the psychology of cognition (information
processing), and the psychology of motivation (activation).
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