Providing hot tips...with realistic odds

All planners know the pitfalls of recommending investments that do not fit the risk profile of their clients. Putting aside the ultimate scenario of a disgruntled investor seeking compensation through the courts, financial planners also know they will not be able to keep their clients if they recommend unsuitable investment vehicles.

All planners know the pitfalls of recommending investments that do not fit the risk profile of their clients. Putting aside the ultimate scenario of a disgruntled investor seeking compensation through the courts, financial planners also know they will not be able to keep their clients if they recommend unsuitable investment vehicles.

But how much do planners know about the inexact science of determining risk profiles? Not enough, according to the authors of Aspects of Investor Psychology.

Daniel Kahneman, the Eugene Higgins professor of psychology at Princeton University and Mark Riepe, vice president of investment products and mutual fund research at US funds management goliath Charles Schwab & Co, argue that there are several things to consider when determining client risk profiles.

And, not all of these behavioural patterns necessarily lie with the client, either. Kahneman and Riepe say financial planners, in determining risk profiles, also need to have a good hard look at themselves.

A good financial planner, they say, not only has to be aware of the "weaknesses of investors that relate to making investment decisions", but must also be able to recognise the weaknesses in their own approach to both their clients and investments generally.

One of the key responsibilities of financial planners is "providing timely warnings about the pitfalls of intuition".

Significant choices are always "a choice between gambles" because the outcomes of possible options are not fully known in advance, Kahneman and Riepe argue. When making a choice, a client will make judgements about the probability of the gamble paying off. But these judgements are always biased and quite often flawed.

One of the major judgement biases is overconfidence and overconfidence is "widespread and robust", say Kahneman and Riepe. Most investors will more often than not believe in a 'sure thing', whereas in reality the scenario is quite different.

"In general, if you are told that someone is 99 per cent sure, you might be well-advised to assume that the relevant probability is 85 per cent."

Even when using a standard gauge to determine the probability of making a return on any given investment, most investors will still overestimate the likelihood of a bet paying off. This is because, even when applying a set of rules to determine risk, two situations will rarely be the same.

Kahneman and Riepe argue there are only two professionals who are able to accurately apply a set of rules to risk - and a financial planner isn't one of them! Meteorologists and handicappers at race tracks face similar problems every day. They make predictions based solely on the probabilities, and get immediate feedback on their efforts. This allows them to apply a given set of rules to risk with the least likelihood of their being biased in their judgements.

Kahneman and Riepe advise planners to keep track of instances of their own overconfidence and to make clients aware of the uncertainty surrounding any investment decision. Planners should not let their client's overconfidence project onto them, or their client will expect too much from the planner and will more than likely leave the planner when his or her high expectations are not met. Most importantly, planners should not overpromise. "Bold statements may help attract clients, but failure to live up to them will come back to haunt the adviser."

Many investors tend to underestimate the role of chance in human affairs and mistakenly recognise games of chance as games of skill, Kahneman and Riepe say.

"The combination of overconfidence and optimism is a potent brew, which causes people to overestimate their knowledge, underestimate risks and exaggerate their ability to control events," they say.

Kahneman and Riepe argue that planners should resist the temptation to concentrate on the upside when presenting historical data to clients, even though it seems bad for business. They should always communicate realistic odds to their clients, and sometimes, focussing on the negatives can be an advantage when dealing with inexperienced investors.

"Because you are more likely to remember your successes, keep a list of past recommendations you made that were not successful," they say.

They add that particularly in finance, the benefit of hindsight will always be put down to skill rather than the random chance that it is. If the All Ordinaries were to drop more than 300 points, within days experts will be coming out of the woodwork to tell you they knew this was going to happen.

Hindsight errors are pernicious in two ways. First, hindsight tends to promote overconfidence, by fostering the illusion that the world is a more predictable place than it is. Second - and this is a lesson that financial advisers often learn painfully - hindsight often turns reasonable gambles into foolish mistakes in the minds of investors. After a stock has dropped in value, its fall appears to have been inevitable. So why didn't the adviser suggest selling it earlier?

Just as in any other form of gambling, investors will always try and stick a pattern to a series of random events. This 'hot hand' tendency owes more to superstition than it does to common sense. In basketball, for example, "observers and participants are universally convinced that players are sometimes 'hot' and sometimes 'cold' relative to their long-term average".

Kahneman and Riepe argue this 'hot hand' tendency is also embraced in the financial world, "where it lends unfounded credibility to the claims of fund managers who have been successful for a few years in a row. The tendency to attribute causal significance to chance fluctuations also leads investors to overreact to any information to which their attention is drawn".

Planners should ask themselves whether they have any real reasons to believe they know more than the market and before making any investment decision, they should consider the probability that the trade is based on random factors.

On clients that that want to switch investments when the market or their gut feel changes, Kahneman and Riepe say: "Investors who own risky assets must commit themselves psychologically to stay with their investments for some time."

When planners prepare account statements for their clients, they should emphasise the long term investment approach by designing statements that give less prominence to the most recent quarter and more to what has happened over the lifetime of the account.

The planner and client should also prepare a set of procedures in advance over what to do if the client has a knee-jerk reaction to a market happening. However, if the client chooses to radically alter their portfolio based on the short term and loses money doing this, the planner should make the client aware of the consequences of this action for future reference.

Planners should be mindful of clients who are prone to regret when making investment decisions for clients. Those prone to regret are likely to blame their financial planner for what they might perceive as a mistake.

Because of this, Kahneman and Riepe recommend planners promote objective factors in preference to emotional factors when making investment decisions. They add that "when there is an extreme mismatch between the client's goals and what actions the client's emotional state will allow, the adviser should consider ending the relationship".

In order to combat regret and aversion to risk-taking, planners should involve their clients in the decision-making process as much as is feasible.

There are no sure fire ways to ensure your client is aware of the risk she or he is taking when making investment decisions, or to make sure their investment portfolio complements their personality. Nonetheless, Kahneman and Riepe believe planners should take steps to minimise the chances of disgruntled clients leaving a planner because of a failure to identify their risk tolerance level. In this way only, they