The Momentum Investments & Oxford Risk Noise and Investment Advice Study brought some interesting facts to light on the effect subjectivity has on the advisor as well. With its purpose to detect variation in investment advice, and to understand where it comes from, it investigated questions such as:
- For the same client, do advisers agree on the risk level they would recommend?
- Which factors, relevant or irrelevant, influence their advice? For example, do advisers project their own attitudes to risk onto their assessments of clients’?
- How much of the variation in advice is seemingly random or due to inconsistency – in other words, how much is noise?
But what is noise, and why should we care about it?
According to the study, the right investment solution should depend on the investor, not the adviser recommending it. “Consistency of advice is a crucial concern for any firm. If what is deemed suitable for a client can differ depending not only on which adviser within a firm they speak to, but also on the prevailing mood of a particular adviser, then that firm has a problem. Especially when we remember that advice isn’t a single event, but an ongoing relationship, and that the regulations care not whether you get it right on average, but whether you get it right for each individual.”
The study points out that humans are prone to ‘noisy’ errors, unduly influenced by irrelevant factors, such as their current mood, the time since their last meal, and the weather. “Noise isn’t bias. Bias is systematic: it errs the same way every time, like a mapping model that puts every client into too risky a portfolio. Noise errs in more mysterious, and therefore less easily manageable, ways.”
But identifying noise isn’t about eradicating inconsistencies. It’s about eradicating unjustifiable ones and evidencing justifiable ones.
The research findings on impact of noise
Given a set of relevant and irrelevant client information, including risk tolerance, advisers were asked to assess each client’s risk capacity, composure (a behavioural trait), and knowledge and experience, and then use these to recommend a suitable risk level plus a high-level asset allocation.
The study showed that there was a large amount of variation in the recommended risk level that doesn’t seem to be driven by the information advisers were given on each client case study. Entropy analysis revealed that overall adviser assessments were closer to totally random than totally consistent.
What influenced the advisers’ behaviour?
According to the study influence can be broken down in four groups:
1. Explicable and relevant
Factors we can explain, and that should affect advice. Within this category, influences can be in the right or wrong direction (for example, risk tolerance correlating positively or negatively with recommended risk level); or should affect advice, but don’t (e.g. risk tolerance changing, but recommended risk level not).
2. Explicable, but irrelevant
Factors we can explain, but that shouldn’t affect advice. For example, the sex of the client, or the age of the adviser.
3. Inexplicable, across advisers
Cross-adviser idiosyncrasies that cause advice to differ in persistent ways, without full explanation.
4. Inexplicable, within adviser
Random errors or inconsistencies that cause advice to differ despite being given by the same adviser to the same set of client circumstances, due to e.g. their mood.
“Noise”, therefore refers to variation that cannot be reliably explained or predicted, i.e. category 4.
The study reminds us that humans are valuable, but error prone and inconsistent. “Where their inconsistencies are systematic, we should provide tools to combat them. Doctors still use checklists. Top sportsmen still use coaches. Chefs still use scales. And in financial advice, decision prosthetics can make advisers more consistently the best versions of themselves.”
“Even if you aim to remove as much bias as possible from the advice that a firm might give its clients, there may be variations in advice that the individual advisor gives to individual clients (possibly influenced by factors such as emotion). However, it is vital that the advice received by every individual client remains as close to their specific objective needs, and not the characteristics of the advisor. Consistency of advice is also crucially important for any advisory firm. This is why being much more aware of noise and how to combat it, is so vital,” according to Greg Davies, head of behavioural science at Oxford Risk.
There is of course another prevalent form of noise – incentives to sell products that earn providers higher fees, or pay more commission, but that is a topic for another article.
Click here to download the “Noise” and investment advice study.