Understanding the Decision-making of Retail Investors

Financial planning and investment by retail investors is fraught with many and increasing difficulties. There is much evidence that the choices they make are often inappropriate, partly due to their poor knowledge of financial products and the specific terminologies. In the UK, many retail investors obtain independent financial advice to assist their decision-making but the process of eliciting their degree of risk appetite leading to investment recommendations has been criticised by regulators and in academic research; there are dangers it may not deliver clients the most appropriate financial products.
The proposed project aims to undertake a comprehensive and wide-ranging investigation of the financial decision-making process of retail investors which will not only contribute to the academic literature on the understanding of how and why investment choices are made, but will also provide practical policy recommendations for risk profiling and the presentation of financial information.

We will have access to two unique databases of the responses of more than 100,000 retail investors to psychometric risk profiling questionnaires with the chosen investments and their demographic/lifestyle data which will be analysed from a number of perspectives with the aim of determining how coherent the process is and the extent to which questionnaire responses already incorporate clients' capacities for loss.

We will evaluate, within the financial advisory process, the impacts of differing methods of data presentation and different terminologies on the investments chosen. For instance, it is now common for IFAs to explain risk via volatility and value-at-risk, which shows, based on historical data, how much the customer is likely to lose with a given probability over a given horizon. However, whether information is presented in a gain or loss scenario has been shown to impact decision-making and in particular risk-seeking and risk-avoidance strategies by individuals. Collectively, we anticipate that these factors may impact the decision-making process of individuals, in particular under conditions of more/less financially knowledgeable retail investors, different levels of excitement or anxiety and across demographic factors such as wealth, gender, education, and age. This aspect of the research will enable us to shed light on the likely impact of determining appropriate investment products via a consideration of the client's lifestyle aspirations (i.e., what do they want to achieve and in what way should they invest in order to expect to meet these goals?) rather than based on their willingness to bear risk.

More broadly, we will step back from the psychometric questionnaire approach and visual presentation of information to consider the impact of the wider circumstances surrounding the financial decision-making process on its outcomes. This will include an examination of the effects of incidental and integral emotions on the decision-making process and outcomes. In the context of financial decision-making, integral emotions that are likely to be felt by retail investors relate to excitement and/or anxiety caused by the decision itself. For example, it has been demonstrated that fearful individuals are more risk-averse, while angry individuals are more risk-seeking. Incidental emotions, on the other hand, are emotions that are unrelated to the decision specifically, but are carried over from previous situations. For example, if a retail investor had a frustrating drive to their appointment with the advisor, or an argument at home, they can be brought to the decision-making scenario and are experienced as the decision is made. There is preliminary evidence that both incidental and integral emotions can influence investment decisions, but a systematic investigation of the impact of both these types of emotions and their interaction with cognitive biases on the decision-making process of retail investors has not been conducted.

It is evident that the subject matter of the proposed research is of considerable practical relevance to those involved with financial decision-making, including financial market regulators, financial advisors, financial planners, and indirectly the investing public at large. The two project partner firms - Distribution Technology (DT) and Courtiers - have already provided advice in drafting the project proposal, and have both agreed to provide support in dissemination of the project findings to non-academic beneficiaries. DT is a provider of financial planning & front office wealth management technology. The organisation serves more than 500 advisory firms and works with more than 70 asset management firms to risk profile over 800 of their funds and portfolios, representing more than £60bn in invested assets and helping advisers assess their suitability. Courtiers is a wealth management firm providing restricted advisory services to a wide range of retail and corporate clients.

The potential beneficiaries thus include:
- Financial market regulators, and in particular the Financial Conduct Authority (FCA) in the UK, who have conducted several reviews of the provision of financial advice, and have recently launched a call for input on this subject jointly with the Treasury. The work ought to also be of considerable interest to regulators outside the UK, particularly in the rest of the EU alongside the introduction of MiFID II, which covers investor protection and the provision of investment services, from 2017. Our research should support the regulatory debates surrounding various issues relating to the advisory process and will provide policy-relevant evidence.

- Financial advisors. Our findings will help to inform the design of approaches to risk profiling and investment selection that avoid common pitfalls in retail investor decision-making - i.e. it will allow financial advisers to utilise a validated measure of risk attitudes, factoring in the emotional environment of retail investors and suggesting ways in which specific unhelpful incidental and integral emotions can be 'neutralised' in the decision-making process. A common process and approach is used by the majority of advisors yet there is virtually no research on whether this actually constitutes best practice. The penalties for organisations which provide advice that is deemed unsuitable can be severe, and thus a process which is structured but not robotic and which is rooted in sound financial and behavioural principles is required.

- Retail investors. The results have the potential to enhance the approach to financial advice which would potentially affect hundreds of thousands of retail investors. Regulatory and academic work suggests that this process does not work well for all retail clients and thus any research which is able to improve the process could indirectly enhance their welfare and the provision of more appropriate investment products. The number of individuals who could potentially be impacted through advisors is vast: for example, currently more than 100,000 clients complete Distribution Technology's risk profiling questionnaire per year alone with advice from over 9,000 financial planners and with £1.2 billion of client recommendations made in 2014 using Distribution Technology's Dynamic Planner interface.

- The Project Partners, Distribution Technology and Courtiers will benefit from the research in this area which is core to their missions and which will support an improvement in the quality of the services that they are able to provide to their clients. By being involved with the research design as it progresses, they will obtain first access to the findings alongside detailed explanations through on-going meetings with the investigators.