Foundations: Decision Consistency and Economic Rationality
Read time 4 minutes
In this post:
- Example Of A Client Lacking Decision Consistency
- Why Do Decision Consistency And Economic Rationality Matter?
- How To Protect Vulnerable Clients And Your Firm
Suppose you present a new client with three different portfolios to choose from – Portfolios A, B, and C.
Portfolio A is aggressive and comprised mostly of equities, Portfolio B has a balance of fixed income and equities, and Portfolio C is conservative and comprised mostly of fixed income investments.
You ask your client what he prefers, and your client answers that he prefers Portfolio A to Portfolio B, Portfolio B to Portfolio C, but oddly prefers Portfolio C to Portfolio A. There are clear inconsistencies in the client’s logic here.
This client lacked economic rationality in his preferences, as he made inconsistent decisions when presented with decreasing levels of risk across the three portfolios. This kind of behavior should raise immediate red flags for an advisor. Clients who display traits of economic irrationality are difficult to manage, but more importantly, do not have a coherent set of risk preferences. It signals that they may fundamentally misunderstand the relationship between risk and reward in an investing context. These are vulnerable clients, who at a minimum require more handholding, and may need even more careful treatment to educate them. They are certainly a regulatory and compliance risk.
To protect both clients and the firm, advisors must understand their clients’ Decision Consistency.
Decision Consistency measures a client’s “economic rationality”–in other words, how well-ordered a client’s risk preferences are. Clients with low Decision Consistency scores show preferences that contradict each other and are an indicator that the client needs extra education and care in the advice process.
In the above examples, we see that the investor with high Decision Consistency takes on incrementally less investment risk as the opportunity decreases, whereas the investor with low Decision Consistency is all over the map in his decision making, regardless of the % of investment risk and the opportunity cost.
In a sample study of 19,000 investors where we calculated each investor’s Decision Consistency, we found that 6% of investors displayed Decision Consistency traits that lacked economic rationality. We also discovered that low Decision Consistency occurs across all Risk Tolerance and Loss Aversion combinations, as well as across all investor ages, meaning that there is no immediately identifiable investor characteristics that can be used to predict clients with low Decision Consistency.
The only surefire way to identify which clients have low Decision Consistency is to use behavioral client profiling methods, such as Revealed Preferences, to mathematically verify which clients are economically irrational and require greater education and hands-on management from an advisor.
To protect vulnerable clients and the firm, advisors cannot afford to overlook the Decision Consistency and Economic Rationality of the client during the profiling process of an onboarding journey.