I recently noticed the advertisement of a specific financial product at a local airport. The billboard referred to the spectacular returns achieved by this product, over the past number of years. If my memory serves me right, the return quoted was about 18 per cent per annum. I specifically looked for the obligatory disclaimer that past performance is not an indication of future performance and that financial products carry risk. Indeed, the disclaimer was there but completely unreadable from where I was standing.
Advertising past performance emits a subliminal message:
“If you buy this product now, you can achieve the same returns in the future.”
You may also recall similar ads (let’s call them high return ads) for offshore investments, small cap or commodity funds. If you believe that returns eventually move back to a historical average, then of course you should be wary of financial products advertised in high return ads. The probability of achieving the same returns in the future is low. In fact, the probability of achieving below average returns is higher, compared to other products that have recently experienced a sub-average performance.
Unfortunately, high return ads are effective because they play on our irrational decision- making patterns. Behavioural finance studies give evidence that when analysing complex situations, we place the most weight on the most recent data we have received. In addition, it is very difficult for us to foresee or predict trend changes, because we tend to extrapolate events from the most recent past.
Other evidence points towards our tendency to avoid complicated thought in favour of jumping to conclusions based on limited information. In one such experiment, conducted in 1996 by Lyle Brenner, Derek Koehler and Amos Tversky, two groups of students were presented with a legal scenario. One group received both sides of the story, essentially acting like a mock jury. The other group was knowingly presented with only one side of the case. This group was more confident and biased with its judgments than the group that had heard all the facts from both sides. They jumped to conclusions after hearing only one side of the story.
It remains a real challenge to sell on any other basis than selling past performance. Financial advisers are frequently faced with the choice of making an easy sell on past performance, rather than helping clients make rational decisions based on a broad array of facts. This might entail having
to choose underperforming products. I have maintained that helping clients make educated and informed decisions is the right thing to do (it is also the law). But when you lose an important client to the past- performance game, it hurts.
Mr High Stakes is looking for a higher yield than a call account. Do you explain a number of options to him; options that have better yields, increased risks and the uncertainty of future returns, even on money market funds? Undoubtedly, he will have to make a complicated decision.
Or do you just offer him the best performing money market fund over the past year? Mr High Stakes has a simple choice to make and is more likely to buy the product. His needs will be met, but he will be left on the likelihood of the product continuing as the top-performing fund or even maintaining the same level of returns.
The FAIS Act does not precisely define what information is required to make a well- informed decision. When you choose the moral high ground, behavioural finance tells us that the odds are stacked against you. High return ads don’t help either. We all have an obligation to fight this battle against the odds.
July, 2012 / Sunél Veldtman / INVESTSA