Menu Close

What behavioural economics tells us about financial adviser greed

Some financial advisers are greedy, but others simply have a bias problem. Shutterstock

There’s no doubt incentives matter for financial advisers. If an employer pays a higher commission to an adviser for selling one product instead of another, it’s likely the commission-linked product will be sold more often.

This basic reasoning was behind the previous government’s future of financial advice (FoFA) reforms. The question is, why is this so – out of pure greed, or do financial advisers just not know better?

I studied the question of pure greed in experiments in 2011, in a study where an expert/adviser knew better than his or her client what was best for the client, and the expert earned different amounts of money based on the client’s decision.

About one third of the participants in our experiment were consistently driven by their own private benefit, that is they always chose the option that generated the highest profit for them. Roughly another third showed behaviour that can best be described as trying to do the best thing for the client, with the remaining third either behaving inconsistently or being driven by some sort of mixed preference, allowing for distributional concerns.

But is this the whole story? The setup of our experiment was such that the expert would know exactly what was best for his or her client. In the case of financial advice in the real world, this may not always be so.

The bias in complex financial decisions

Financial advice is an expert service. A customer asks an adviser for assistance with making a better decision, expecting that the expert adviser is more knowledgeable and – maybe more objective - than he or she is.

While there’s plenty of literature documenting that household financial decision making is far from perfect, the standard assumption about economic advisers is that they do not make such mistakes.

Given that financial advisers are human beings, this is at least a questionable assumption. Financial products are, almost by definition, complex products. It is often hard to understand which aspect matter and, to make things worse, feedback about whether a decision was correct is slow and rare. This makes it hard for any decision maker to overcome a cognitive bias.

It is likely that even the most experienced financial advisers will be subject to biases in their decisions and the advice they provides to a client, even if they have only the best interests of a client at heart.

Thinking, Fast and Slow author Daniel Kahneman provides an answer to the question of how a financial adviser may react when facing complex decisions: he or she may substitute the hard question with an easier one.

For example, if the real question a client has is “should I invest in a hybrid security” or not, the adviser may substitute this question with the question, “how popular are hybrid securities among this customer group”? This is a different question, but as Kahneman documents, such substitutions usually go unnoticed.

And in this situation, the role of commissions to financial advisers becomes even more important.

For one reason, the adviser may simply substitute the question “what is best for the client” with “what is best for me” – which is definitely an easier question as the commission structure is easy to identify. Furthermore, this answer allows the adviser, should something go wrong, to blame his or her employer because the decision was simply reflecting the incentives he or she got from the employer.

Why education is flawed

Can education help in this case? Yes it can, but given that financial products are complex by nature and learning is slow given that there is no quick feedback, “technical” education is not the answer.

Instead, education should raise awareness to biases and provide advisers with strategies to overcome them. Technical solutions can help but do not solve all problems, as people are likely to overweight information confirming their predispositions and underweight information that conflicts with this predisposition.

This is where organisations employing advisers can play a critical role. As Kahneman points out, organisations have the potential to establish quicker feedback loops, as it’s much easier to see the mistake a colleague makes than to see your own mistake. This channel to avoid weak financial advice is one that tends to be overlooked in the current debate.

Want to write?

Write an article and join a growing community of more than 186,700 academics and researchers from 4,994 institutions.

Register now