A basic understanding of investor psychology can help your clients make better investment decisions.
We all have biases that affect our decision-making – and for investors they often come to the forefront during challenging markets. The good news is that, when it comes to biases, a little education often goes a long way. Simply knowing that biases may be at work, skewing perspectives, can help your clients choose consciously to ignore them. Here are four of the most common investor biases, along with strategies you can suggest your clients use to overcome them.
“Just as I expected”
Let’s say you read a study that says chocolate is good for your health. “Okay,” you think, “sounds good to me.” The next time you encounter news about chocolate, you’ll screen it against the opinion you’ve already formed. If it agrees with that opinion that chocolate is healthy, you’ll give it more weight. If it doesn’t, you’ll be more likely to dismiss it.
That’s a simple example of confirmation bias in action. Our brains work hard to study the world and come up with opinions. Once they’re formed, we have a tendency to take shortcuts in our thinking, so we don’t have to spend our lives re-evaluating every one of our opinions. It’s efficient, but it may interfere with good decision making.
“Investors make irrational decisions during volatile markets because of the fundamental nature of the way the human mind works. We have two modes of decision making, System one and System two. System one is relatively effortless and intuitive. System two is effortful and highly rational and considers information rather than emotion. We tend to become more biased towards System one during market volatility.”
– Dr. David R. Lewis, Chief Client Officer, BEworks
A good way for clients to combat confirmation bias is to deliberately seek out and strive to be open to opinions that contradict their own. In addition, second-guessing can become part of the decision-making process, providing an opportunity to probe carefully to see if a decision is well supported by all the available evidence.
“Don’t make me regret it”
Maybe you’re considering whether to go on a camping trip with a group of friends. Questions start to pop into your mind: What if markets tank and clients need me? What if we get lost in the woods? What if I regret signing on – or not signing on? Should I stay or should I go?
Regret aversion is a bias that can paralyze decision making. The fact is, we don’t like being wrong, and being wrong can happen when you take an opportunity or when you pass it up. In investing, this bias may make clients reluctant to buy because they are worried about how they will feel if an investment declines in value. It may make them reluctant to sell at a loss to avoid admitting they were wrong. Or it may stop them from making any decision at all.
A strategy to counter regret aversion is to take a step back and systematically evaluate the pros and cons of a potential course of action based on data rather than emotion. Remind clients that while it’s not possible to eliminate the possibility that they will regret a specific choice, they can focus on making an informed decision grounded in reliable information.
“It’s not you – it’s me”
Or is it the other way around? You win a game of Monopoly and think privately, “I could be a real estate tycoon!” You lose the next time and shrug it off as bad luck. Another bias is at play.
The self-serving bias makes us attribute positive outcomes to our own smarts, and negative outcomes to broader forces beyond our control. An investment’s price rises? Must be stock-picking savvy. It drops? The markets have it all wrong. The consequences for investors may be overconfidence that leads to skewed decision making.
“People tend to believe that they made the right decision and any negative outcome of that correct decision was due to the influence of a third party. So even though an investor may choose to pull their money out of the market [in volatile times], they tend to attribute that blame to the financial advisor. Even though it was their own decision.” – Dr. David R. Lewis, Chief Client Officer, BEworks
To minimize the effects of the self-serving bias, investors may want to jot down their reasons for buying any given investment. However it performs, they can revisit their decision-making process and learn from it. It’s worth reminding your clients, too, that most investment outcomes – positive and negative – depend on a mix of individual skill and broader factors.
“Follow the money”
It’s the season’s hottest toy. You track one down for a young family member, wrap it up and congratulate yourself on finding the perfect birthday present. But two weeks later, it sits abandoned in a drawer, replaced by the new “it” toy.
Even though we know that past performance is not indicative of future results, it’s hard to arm ourselves against the trend-chasing bias. Investors like winners. It can also be satisfying to feel that we’re participating in a broader movement. The trouble is that soaring sectors and stocks tend not to repeat their outperformance year after year.
Basing investment decisions in a fact-based assessment of opportunity and risk can help mitigate investors’ natural inclination to jump on the bandwagon. Then, once your clients have committed to investing in a specific way, setting up regular deposits can help them stick to their plan – and benefit from dollar cost averaging too.
Awareness is the first step
Investor biases have the potential to detract from long-term performance, but being aware of them can help your clients minimize their impact. Educating your clients and building a plan based on a solid understanding of each individual’s risk tolerance and goals can help clients overcome biases – and help you develop trusting relationships with clients.
Learn more about investor biases and how you can help your clients navigate through volatile markets here.
“Incorporating behavioural economics helps advisors understand the reasons why clients are making decisions, and if you can understand why they are making these decisions, you can then consider tactics to help them overcome those sub-optimal decisions.” – Dr. David R. Lewis, Chief Client Officer, BEworks