When a client makes an investment decision, they get influence from friends, family, peers, media and industry data. Behavioral biases are another factor that comes into play that clients are not typically aware of.
Behavioral biases affect how investors feel and act when it comes to investment decisions; they are typically influenced by emotions, rather than fact or data.
Understanding the difference behavioral biases and how they impact client decision-making can give advisors the tools to better serve clients and achieve greater financial results.
Here are a few of the most common behavioral biases:
When a client’s confidence is greater than the accuracy of their belief, they have an optimism or overconfidence bias.
For example, if you were to ask drivers if they have above-average driving skills, the large majority would say they do. Next time you’re on the highway, you’ll understand why this is an overconfidence bias.
When it comes to investors, there are two levels to the overconfidence bias: a feeling of surety in their information, as well as their ability to act appropriately for the optimal gain.
To overcome this bias, financial advisors should notice if clients are inclined to trust their “gut” instinct over market insights and data.
When a client believes or wants something to be true, they will evaluate confirming information more favorably than information that disproves their assumption.
While clients may believe they’ve done their due diligence, gathered sufficient data and evaluated all the facts, they’re more inclined to ignore opposing evidence (regardless of how reliable), to support their own beliefs.
In other words, they will ignore unfavorable information if it disproves their narrative.
An aversion to loss is normal, especially when it comes to money. Losses are felt nearly 2-3 times more strongly than gains.
The problem with a loss aversion mindset is that it can lead to inaction and missed opportunities. Loss aversion favors status quo over risk-taking, even when the risk is low or reasonable.
Those with a loss avoidance bias tend to make lofty projections, yet take meager action.
When something great happens, we take the credit; when something bad happens, it’s someone else’s fault. That is the gist of the self-serving bias.
Investors will a self-serving bias are unable to take accountability for their actions and typically have a victim mentality.
Choice is a great thing until it comes into excess. There was a study conducted where shoppers were given the opportunity to sample over two dozen varieties of jam at their local grocery store.
At first, the shoppers were delighted, but when it came time to make a purchase decision they were so overwhelmed by the options, they were unable to make a decision.
When the same study was conducted with just six varieties of jam, shoppers were more likely to make a purchase and consequently more satisfied with their decision.
The same scenario is applicable in investing. There are thousands of investment opportunities, but that’s not always a good thing.
Advisors can mitigate choice paralysis by getting to know their clients’ goals and objectives, then only offering options which align. Too many choices can lead to indecision and subsequently inaction — not good for both parties.
When there are too many options, some investors will choose to focus on the information only at the tip of their own nose. They are resistant to digging deeper or doing extensive research because it may complicate their decision-making.
As a result, investors are content with making a satisfactory decision based off of minimal research, rather than the optimal decision. This phenomena is greatly associated with a short attention span.
As an advisor, if you notice your clients basing their decisions off a single source, encourage them to seek alternative resources. For example, media can be a big influencer, but shouldn’t be a primary resource for information.
Investors love patterns — it gives them a feeling of security and surety. However, making decisions based on assumed “patterns” can be a false prophecy and actually lead to poorer performance.
To a certain extent, the market is random and relying too heavily on trends can dangerous. Following the crowd is a favorite of trend chasers; it offers a “we’re all in this together” mentality.
Encourage your clients to seek opportunities which are right for them and not just because everyone else is doing it. If the best investment for the client also happens to be a popular trend, so be it.
This is perhaps the trickiest bias of them all because it means the client is completely unaware of their biases. Without a certain level of awareness, eliminating biases won’t happen.
While a client may believe other investors suffer from a bias, they themselves believe they are above the cut; essentially unaffected.
Dealing with behavioral biases can be complicated and difficult, even for the most experienced advisors.
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