Behavioural finance identifies and explains biases that detract from our ability to make rational financial decisions. Understanding of these human biases can help a financial advisor to better understand a client’s choice, and is an important step toward developing financial strategy that meets clients’ investment objective. Behavioural biases can be placed into two broad categories: cognitive and emotional biases.
Cognitive biases are challenges in processing the available information correctly. An example of an cognitive bias is when investors are overconfident in a judgment about the future and give undue importance to past performance of investment. This is a big issue for clients as well as for financial advisors. Human minds like to see trends, even amidst randomness. Anchoring and Sunk Cost are examples of cognitive bias.
Anchoring refers to an over-reliance on first piece of information available. For instance, if investor thinks that a CEO of a particular company is a successful person they may be too confident that stocks of that company are a good bet. This preconception may be incorrect at some point of time. In order to avoid this trap, investors need to remain flexible in their thinking, and open to new sources of information.
Sunk Costs fallacy
The sunk cost fallacy is just as dangerous. Investors psychologically think that they are correcting their previous incorrect decisions, which is often disastrous for investments. Such investors are not ready to accept to the fact that they made the wrong choices. If your investment is no good, or sinking fast, it is wise to get out of it as soon as possible and get into something the better. It’s far better not to cling to the sunk cost and to get into other investment options that are performing better. Emotional commitment to bad investments just makes things worse.
Emotional biases relate to the excessive influence of emotion on our decision-making. Though humans cannot avoid taking emotionless decisions yet advisors can focus on areas that can control client’s emotions rather than supporting it. There are various factors, such as short-term thinking, loss aversion and herding, that may influence investment decisions negatively..
Loss aversion is an emotional bias. Study confirms that investors feel the pain of even small losses significantly more than the pleasure of larger gains. Implication of loss aversion is that it prevents individuals from selling underperforming assets, even when significant evidence indicates that there is no prospect for improvement in their holdings. The pain of realizing a loss by selling is so great that often investors remain invested in hopes the investment will turn around. Rather than evaluating performance relative to a reference point where they first bought the asset. advisors can focus attention on the investment value of alternative investment options and their relevance to a client’s financial goals.
Another common investment challenge is herding behaviour. Some investors have tendency to mimic the action of a larger group. This action may be rational or irrational. The pain of social exclusion for most clients is too great to bear. Though these investors may know that the decision they are going to take doesn’t sound correct yet they believe that decision of such a large could not be wrong. In case the decision goes wrong they know that they are not alone.
Michael Pompian author of the book Behavioral Finance and Wealth Management, identifies eight investor personality types and their biases. Pompian suggests that once the investor types have been defined, the advisor can design an asset allocation strategy to mitigate the biases. However, there are challenges in following that as the client behaviour can be situational. For instance, a risk-averse investor can become risk-seeking in the different situation. Though the behavioural finance does not have all the answers to wealth management it is, however, extremely helpful in developing productive, long-lasting client relationships that help a client as well as financial advisor to avoid common and predictable investing mistakes.