Academic journal article Financial Services Review

How Analytical Is Your Financial Advisor?

Academic journal article Financial Services Review

How Analytical Is Your Financial Advisor?

Article excerpt

Abstract

We survey over 100 financial planners to assess their reasoning mode, intertemporal choices, risk aversion and preferences, and framing focus. Using the Cognitive Reflection Test, we find that financial planners are more analytical than the general population. Further tests show that the analytical planners are more financially patient and perform better in intertemporal choice problems. These attributes seem important to successful financial planning. Intuitive thinkers were more risk averse and behave more according to the axioms of prospect theory. One-third of our planners were fooled by the framing of a question. © 2007 Academy of Financial Services. All rights reserved.

JEL classifications: D81; D91; G29

Keywords: Financial advisor; Cognitive Reflection Test; Intertemporal choice; Risk preferences

1. Introduction

People are being asked to manage more of their own wealth. The shift toward investment autonomy can be seen in the worldwide trend toward self-directed retirement accounts (like defined contribution plans) and away from employer or government directed benefit programs. However, there is some question as to whether individuals are capable of making effective investment decisions. Baker and Nofsinger (2002) summarize the many cognitive errors, psychological biases, and emotions that frequently influence investor decisions. Bailey, Nofsinger and O'Neill (2003) illustrate that many people may not be suited to making effective retirement investment decisions. They may believe that professional investors are less susceptible to such problems. Indeed, Byrne (2007) finds that a large portion of employee survey respondents in the United Kingdom do seek independent financial advice.

The question of whether professional investors actually are less susceptible to such problems is still open, the evidence is mixed. For example, in the examination of brokerage accounts in Israel (Shapira & Venezia, 2001) and China (Chen, Kim, Nofsinger & Rui, 2007), individuals tend to exhibit a stronger disposition effect than do professional investors. On the other hand, studies on professional United States futures traders (Covai & Shumway, 2005) and on U.S. mutual funds (e.g., Frazzini, 2006) find that institutional investors exhibit similar degrees of the disposition effect as individual investors. There is little research in comparing professional and individual investors in risk and intertemporal preferences.

Frederick (2005) discusses the intertemporal choice mistakes and risk preference patterns of people (mostly students). Kahneman (2003) shows that the problems people have making decisions are related to the context in which the question is framed. In short, people suffer from time preference problems, behave according to the axioms of prospect theory risk preferences, and are fooled by the framing of a question. These mistakes seem to manifest themselves within retirement saving behavior (Jacobs-Lawson & Hershey, 2005). As an alternative to making these investment decisions alone, many people seek advice from financial advisors (Allen 2001). However, little is known about the cognitive ability and biases of financial investment advisors. Advisors have education, training, and experience that could mitigate their biases and help clients with the investment process (Volpe, Chen & Sheen, 2006). On the other hand, financial professionals may have incentives to form suboptimal portfolios and select expensive investment products (Jones, Lesseig & Smythe, 2005). Most research on intertemporal choice mistakes, risk preferences, and framing has been conducted using nonprofessionals.

This study investigates the psychological profile of one type of financial advisor, the personal financial planner. We first measure the reasoning mode tendency of the financial planners and classify them as intuitive decision makers or analytical decision makers. …

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