How the Behavioral Sciences Impact Fiduciary Outcomes

Written by: Don Trone and Matt Luksa

With our increasingly litigious, volatile, complex, and ambiguous world, fiduciaries must take a holistic approach to decision-making. They need to know how every decision is interconnected and that there are consequences if a particular regulation, rule, or best practice has not been prioritized or properly executed.

Given these circumstances, does a fiduciary have responsibility to be familiar with behaviors and biases that may impact the quality of their decision-making process?

What prompted this article was news of the recent passing of Professor Daniel Kahneman, who was one of the leaders and pioneers of the Behavioral Economics (BeEc) movement. Dr. Kahneman is best known for his research that studied human judgment and decision-making, and why people deviate from making rational decisions. For his work, in 2002 he received the Noble Prize in Economics.

Behavioral Finance (BeFi) is the follow-on to BeEc. Professor Richard Thaler is credited with being one of leaders that identified biases that keep individual investors and retirement plan participants from making rational investment decisions. For his research, Dr Thaler received the Noble Price in Economics in 2017.

Behavioral Governance (BeGov) represents the latest research in the behavioral sciences. BeGov is anchored by the groundbreaking research in neuro-leadership, which was developed by Professor Sean Hannah and his research colleagues. BeGov differs from BeEc and BeFi in that it studies the innate traits and behaviors that amplify, infuse, and improve the decision-making outcomes of those who are subject to a fiduciary, governance, or project management standard.

A note about behavioral biases: A behavioral bias is a systematic pattern of deviation from a procedurally prudent process. Most, but not all, of the biases associated with BeEc and BeFi can cause a key decision-maker to make procedurally poor decisions. For this article, we will only reference those biases that may potentially cause such a negative impact.

We’re going to break the remainder of this piece into three sections – Neurological Capacity, Leadership Behaviors, and Stewardship Behaviors. Each section represents a critical feature of the Behavioral Governance framework, and at the end of each, we will list the biases (BeEc and BeFi) that may deplete the quality of decision-making outcomes.

Section One: Neurological Capacity

BeGov: The following are six neurological markers associated with neuro-leadership. These are innate traits (mental capacity that you were born with) that help to identify exemplary key decision-makers who have liability for their governance process.

• EXECUTIVE CONTROL: Demonstrating the ability to regulate thoughts and emotions to resolve conflicts between impulsive desires and adherence to the achievement of longer-term goals.

• PROCEDURAL JUSTICE: Enacting a fair, just, and transparent process to resolve moral conflicts or to allocate limited resources.

• SELF-COMPLEXITY: Understanding one’s own self within changing roles and requirements, and the ability to adjust and adapt thoughts and behaviors to enact more appropriate responses to ill-defined, changing, and evolving situations.

• SITUATIONAL AWARENESS: Having the capacity to: (a) perceive changes in one’s environment, (b) interpret changes to determine whether and how changes may impact goals and objectives, and (c) make predictions as to how changes may impact future events.

• SOCIAL ASTUTENESS: Possessing the capacity for: (a) social intelligence, (b) interpersonal influence, (c) networking ability, and (d) sincerity.

• VISION – INSPIRATION: Demonstrating the capacity for transforming leadership, and the ability to connect with others and provide shared visions and strategies that engage, gain commitment and alignment, and inspire higher levels of performance.

BeEc and BeFi: The following are biases that may keep a key decision-maker, such as a plan sponsor or a plan participant, from making a procedurally prudent decision:

• AVAILABILITY BIAS: Focusing on what easily comes to mind (often vivid or recent events) and giving undue weight to those events.

• DECISION PARALYSIS: Making no decision at all when too many options are presented.

• DEFAULT BIAS: Picking the easiest option to avoid complex decisions.

• DISPOSITION EFFECT: Holding on to poor investments too long and selling good investments too soon.

• FRAMING: Simplifying complex problems and substituting solutions to the abridged problems in lieu of solutions to the complex problems.

• HINDSIGHT: Predicting future events from past events, and predicting outcomes of actions (“I knew it along”).

• HYPERBOLIC DISCOUNTING: Putting an overly high value on the here and now and an overly low value on the future.

• LOSS AVERSION (See also PROSPECT THEORY): Focusing more on preventing losses than making gains.

• OPPORTUNITY COST NEGLECT: Ignoring what is given up when making choices.

• PLANNING FALLACY: Underestimating how long things will take and how many resources will be required.

• PROCRASTINATION: Failing to properly manage time and waiting until the last moment to do anything.

• REPRESENTATIVE BIAS: Making judgments based on how people or situations match stereotypes. 

• STATUS QUO: Being committed to keeping things the way they are.

• SUNK COST EFFECT: Seeing commitment grow for a strategy once an investment has been made.

Section Two: Leadership Behaviors

BeGov – Leadership Behaviors that may amplify, infuse, and improve the decision-making outcomes of those who have liability for their governance process.

• CHARACTER-FULL: Emphasizing values/principles during decision-making; acting in moral and ethical ways.

• COLLABORATIVE: Encouraging others with different viewpoints to voice ideas/opinions; creating a shared commitment to achieving objectives.

• COMPASSIONATE: Placing the interests of others first; showing empathy when dealing with others.

• COMPETENT: Exhibiting proficiency and expertise; maintaining knowledge of the latest best practices.

• COURAGEOUS: Remaining resilient despite setbacks; taking a stand on issues when needed.

BeEc and BeFi: The following are biases that may deplete the quality of prudent decision-making outcomes:

• ANCHORING: Being tied to a previous decision.

• EGO DEPLETION: Making poor decisions because of mental fatigue.

• ENDOWMENT EFFECT: Overvaluing what one owns.

• HERDING: Doing what others are doing.

• SELF-SIGNALING: Behaving in ways that reinforce the type of person one believes themselves to be, even if no one else is around to witness it.

Section Three: Stewardship Behaviors

BeGov – Stewardship Behaviors that may amplify, infuse, and improve the decision-making outcomes of those who have liability for the results.

• ACCOUNTABLE: Providing responsible stewardship for the resources of others.

• ADAPTIVE: Balancing risks and rewards when making decisions; adapting behaviors to enact responses to ill-defined, changing, and evolving situations.

• ALIGNED: Ensuring decisions are consistent with standards, procedures, policies, or regulations.

• ATTENTIVE: Seeking all relevant information before making decisions.

• AUTHENTIC: Ensuring words and deeds are consistent with stated core values.

BeEc and BeFi: The following are biases that may deplete the quality of prudent decision-making outcomes:

• ACTION-GOALS GAP: Failing to follow through on commitments.

• CONFIRMATION: Using evidence to confirm our beliefs or claims and overlooking disconfirming evidence.

• OVERCONFIDENCE: Believing one is right and everyone else is wrong.

• LIMITED ATTENTION: Focusing on a limited number of things which may mean important details are missed.

• MENTAL ACCOUNTING: Categorizing and treating money differently depending on where it came from and where it is going.

• REWARD SUBSTITUTION: Appealing to people’s impulsive nature for behaviors that may be good in the long run.

• SCARCITY: Being motivated by shortage.

To improve the management of investment decisions, we need to have a better understanding of the behavioral sciences. There are traits and behaviors that amplify, infuse, and improve decision-making outcomes, but also biases that can have a drag on a procedurally prudent governance process.

So…does a fiduciary have a responsibility to be familiar with behaviors and biases that may impact the quality of their decision-making process?

We think the answer is a resounding, ‘Yes.’

Don Trone is the CEO of 3ethos and of the Center for Board Certified Fiduciaries. He is regarded as the ‘Father of Fiduciary’ and was the principal founder of fi360 and of the AIF and AIFA designations.

Matt Luksa is VP, Retirement Relationship Manager, for Retirement Investment Solutions at First Eagle Investments.  He is a Certified Retirement Plan Specialist and Accredited Behavioral Finance Professional through the College of Financial Planning. Matt’s career is nearing 20 years of experience with additional firms of Dimensional Fund Advisors, John Hancock, and global leadership in Toronto, Canada, with Manulife Investments.

Examples of framing, representativeness, availability, anchoring, and herding to name a few. 

While it’s vital to control for costs, when a plan sponsor solely considers cost or overweight’s cost when making decisions, this can create mismatches between goals for plan sponsors and needs of participants.  As an example, picture key decision makers of a plan sponsor were looking at RFP’s from two different recordkeepers and on that same particular day they had just met with a prospective client where this new deal could make it a record breaking sales year for their business.  However, they lost the deal and the reason provided was because fees were too high.  That unfortunate news is not uncommon to become prominent in impacting other meetings, day to day activity, and general mood of the key decision makers.  And now they’re looking at two RFP’s side by side where fees seem to be jumping off the page.  If key decision makers are not trained at making decisions under stress and the guidance received from an advisor is limited to just getting agreement from the plan sponsor, there’s greater potential their plan participants’ best interest might be overlooked by underweighting the comparison of services, tools, customization, and overall value for the proposed expenses by each recordkeeper.  Instead, if an advisor is situational aware of outside influence that’s impacting decision making, they’re ability to implement a governance framework that incorporates leadership and stewardship qualities will allow space to take pause, seek perspective, and effectively communicate in a trustworthy manner.

Another example related to costs that can impact decision making is from investment analysis.  A common approach when comparing two mutual funds with similar average annual returns is to select the fund with lower fees.  However, what is disregarding from the decisions is the journey in which these returns were delivered.  Keeping in mind average annual returns are net of fees, a fund that produces similar results but with lower lows and lower highs, is delivering a more consistent return profile, or said another way, a better investment experience (see chart 1).  Most investment scoring methodologies and Investment Policy Statements work on a point system that gives scoring weight to 1-yr, 3yr, and 5-yr numbers and risk metrics like standard deviation and tracking error.  While this is an attempt to identify funds with superior returns, they’re more accurate at telling what will deliver market like returns versus maximizing long term wealth.  This is partly due to a focus on overweighting short term performance.  If a score is given to each 1, 3, and 5 year return figures, the 1 year return number is also a 1/3 weight in the 3 year, and a 1/5 weight in the 5 year.  The other and bigger picture challenge is plan sponsors and advisors work with numbers measuring average annualized returns, while participants’ real world experience is measured in compounding returns, where negative returns impact the ability to compound wealth because the rate of return and time variables are working against the formula for Time Value of Money.  So then why do we use simple average annual returns and chase low fees, because its easier to calculate for comparison purposes than compounding returns.  Having an easy button is 100% behavioral finance and deemed a good thing.  The ability to better align investment analysis with participant experience requires training in leadership, stewardship, governance because even with the right purpose, it will be consistently challenged by industry status quo and herd mentality.

Chart 1

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