So, what are some typical behavioural biases your clients might exhibit, how can you help them to see it in themselves, and above all, how can you steer them towards better decisions? I’ve focused on five below.
1 - Herd Mentality
This relates to investors basing their decisions on the actions of others. Herding, whether spurious (making similar decisions to others) or intentional (deliberately imitating behaviour), can be detrimental. It is very similar to chasing trends or the ‘bandwagon effect’.
As an example, one only needs to see how much of the ‘new money’ committed to mutual funds each year ends up in the funds which performed best the previous year – often more than 40 per cent.
How to recognise and how to avoid: clients may discuss when they should enter or leave the market. They may mention stocks, funds or fund managers they have heard about in the media; they may even talk about ‘missing out’ on a stellar opportunity.
Demonstrate that staying invested and following a plan offers the best opportunity to achieve their financial goals, as opposed to flavour of the month stocks that can quickly turn sour.
2 - Anchoring Bias
Investor decisions can be influenced by fixating on a reference point due to uncertainty of assets. They then go onto make comparisons and estimates based on this which is known as anchoring, even though the reference point itself is arbitrary and irrelevant, and perhaps simply the first piece of information the investor heard.
Anchoring can result in the ‘disposition effect’ where subsequent investment decisions can be negatively affected by holding onto losing stocks or funds for too long or selling winning ones too early.
How to recognise and how to avoid: Clients may frequently refer to a single reference point, whether that be media or an individual, as their source of the ‘truth’.
To help them be more objective, advisers should be comfortable questioning these sources and provide alternative viewpoints, perhaps even playing Devil’s advocate to build a counter-argument in order to challenge the client’s thought processes.
3 - Overconfidence Bias
Overconfidence can have two components: overconfidence in the quality of your information, and overconfidence in your ability to act on that information at the right time for maximum gain. Investors who are overconfident and over-optimistic may take greater risks, attempting to time the market due to a perceived level of skill and illusion of control. It can also be increased by ‘confirmation bias’ - where new information that supports an existing opinion increases confidence.
How to recognise and how to avoid: Overconfidence can manifest in a client overestimating their investment knowledge and underestimating their perceived level of risk. By scrutinizing both areas, advisers can help them gain a more accurate picture and understand their limitations.
