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Advisors need not master the concept, but some working knowledge of behavioral finance can go a long way toward helping clients avoid financial pitfalls and regrets while helping them stay the course through tumultuous market environments.
Whether it's preventing clients from embracing small, fly-by-night cryptocurrencies or dumping an asset simply because it's correcting, advisors are already engaging in some level of behavioral finance whether they know it or not. By some estimates, approximately 80% of advisors say they engage in some form of behavioral finance with clients.
Fortunately for advisors that are not yet initiated to behavioral finance, the concept’s foundations are easy to understand. It’s the science of how and why people make various financial decisions and those include everything from home buying, activity in markets, retirement planning and more.
For advisors that want to bolster their behavioral finance acumen, three pillars should be emphasized: cognitive, emotional and social. Let’s explore those concepts below.
Emotions Matter
The cognitive element of behavioral finance centers around a person’s ability to think and ability reason – two extremely important concepts as they pertain to money. Within cognitive bias, there are two biases to pay particular attention to availability and confirmation.
Confirmation bias is easily explained and it’s on full display in much of our daily lives. One way of looking at it is that confirmation is akin to narrative building. It’s human to nature to consume information with which our views align. For example, a person might have in their mind that they want to see a particular movie and they go on Rotten Tomatoes, but make it a point to consume only positive reviews about the film. Sounds innocent enough, but when that logic is applied to money and investing, it can be potentially perilous.
Availability bias is different, though equally as prevalent and potentially just as negative as confirmation bias. This bias revolves around what the client or investors most recently consumed.
“For example, you may feel more confident and willing to take on greater risk during a market rally. Or you may avoid a certain stock if you previously held it in your portfolio and experienced a loss, even if new facts or the news cycle may change the company’s outlook,” according to US Bank.
When it comes to emotional biases, advisors should help steer clients away from two primary ills: the expectation that regret is looming and fear of losses. The former is self-explanatory, yet many novice market participants enter investing thinking this is an easy racket and losses are easy to avoid. But loss aversion is a different beast. It pertains to investors’ skittishness, i.e. selling winners too quickly.
On the other hand, regret anticipation is different, but it can be easily quelled by seasoned advisors.
“Anticipated regret could result in you investing without doing your due diligence for fear of missing out on big returns in the future. On the other hand, anticipated regret could also manifest itself if you chose not to invest because you didn’t want to lose money if the company ended up failing,” adds US Bank.
Thwarting Social Biases
Arguably, social biases are the hardest to defeat. Clients can suffer from fear of missing out (FOMO), envy of others’ success in markets, falling victim to uninformed musings in the press and social media and overall herd mentality.
Clients need some level of self-awareness to fess up to those behaviors, but when they do, they can tap advisors to get back on the right track and avoid falling prey to biases, social and other, in the future.
“Working with a financial advisor and developing a comprehensive financial plan can help you manage your potential behavioral finance biases. For example, a plan can remove availability and groupthink biases by keeping you focused on long-term goals instead of reacting to current market events or making changes to your portfolio based on a layman’s opinion,” concludes US Bank.
Related: Clients Economic Views Highlight the Need for Advisors