6 Industry Biases and How Financial Advisors Can Avoid Them

People base their decisions on emotions and biases. One study conducted by neuroscientist Antonio Damasio found that even when one makes what they believe to be a logical decision, the very point of choice is arguably always based on emotions.

In the financial services profession, it's easy to tell when a client's opinion is swayed by something they read in the news or heard from a trusted colleague. Financial advisors deal with clients who make emotionally-charged decisions frequently. But what many advisors don't realize is that they can fall under the influence of the same industry biases as their clients if they aren't careful.

Below are six types of industry biases that can affect financial advisors, plus expert tips to avoid them.

1. Bounded rationality 

It is a bias that affects many advisors, whether they accept it or not, and is influenced by existing constraints on information, cognitive ability and time. Assistant Professor of Management at The American College of Financial Services Gerry Herbison coined the term "satisficing" to describe the concept of "good enough" in decision-making. Satisficing decision makers may not be able to make the best recommendations to clients because they are constrained by time and lack the full scope of information necessary to make an optimal recommendation.

Don't make recommendations that are rooted in heuristics - the equivalent of decision-making shortcuts based on rules of thumb, assumptions, and historical data. Take time to analyze and investigate a client's hopes, dreams, goals, and needs. Pursue lifelong learning to keep abreast of changes in the industry and to ensure the advice you give is as well-informed as possible.

2. Overoptimism

The belief that one can affect events more than they actually can. While it is true in most cases that financial advisors know more than their clients, it is important never to get carried away with yourself and your expertise. Confidence is good; overconfidence can lead to poor advice. Prevent falling into the overoptimism trap by always taking the time to get a second opinion on recommendations you are making to a client. 

3. Overconfidence

The belief that one is more likely to succeed or less likely to fail than another individual. Frequently occurring in addition to overoptimism, an overconfidence bias can lead to irreparable damage to clients if left unchecked. 

One way for financial advisors to keep from falling under the influence of overconfidence is to use the Assess-Search-Construct (ASC) model of choice developed by Dr. Winston Sieck, Ed Merkle and Trish Van Zandt of Ohio State University. The ASC model requires advisors to:

1. assess each investment solution or recommendation independently
2. make an assumption that each option is the best one, then
3. search their memory for facts to back up the assumption, and finally
4. explain why the option is best in writing

4. Herding

Following the leader commonly happens whenever a new initial public offering (IPO) comes out, or a new living benefit rider for an insurance or annuity product becomes available. Sometimes it can be easy for advisors (and clients) to get swept up in the latest new offering or investment product. To prevent suffering from a herding bias financial service professionals and advisors must manage their emotions, conduct due diligence, and fully understand the objectives - or curtail the emotions - of their clients.  

5. Irrational exuberance

Trusting your gut/intuition is a behavioral response that has helped numerous athletes reach the Hall of Fame. In the financial services industry, irrational exuberance is a trait that many advisors do not have the luxury of exercising, especially when their clients' financial security is at stake. While a high level of expertise can breed certain amounts of legitimate exuberance, it's crucial that advisors don't allow their emotions to run wild. Financial advisors must take care to operate based on the best research available, and cross-reference it against client objectives, time horizon, and risk tolerance.

6. Framing

At its very core, is the way advisors say things to their clients. People are emotional beings and often inject their feelings into interpretations of what others say. Advisors and financial planners regularly encounter individuals who are experiencing a broad range of emotions as it pertains to achieving financial security. For this reason, and because every client's situation is unique and requires unique advice, it's crucial for retirement planners and financial advisors to present relevant information and recommendations to clients in a way that it will be received and understood.

Honing your skills at presenting relevant information in different ways will help get the right message across to the right client. Financial advisors have an opportunity to be their clients greatest guide or worst deceiver, it all depends on the presentation of recommendations!

Financial advisors who act logically and rationally, remaining calm and level headed while taking an educated approach to helping clients achieve their financial objectives, can improve their chances of avoiding the industry bias trap.

A comprehensive understanding of core financial planning areas can help advisors make logical, informed and beneficial recommendations for their clients.  Advanced education and earning an advanced designation like the Chartered Financial Consultant® (ChFC®) can strengthen your ability to efficiently serve clients and be the trusted advisor they need. Learn more about becoming a stronger advisor with our guide, How the ChFC® is a Game Changer in Advancing Your Financial Planning Career.