When clients make undesirable financial or investment choices, it is often the result of biases and heuristics. Cognitive bias occurs when drawing incorrect conclusions, based on an ill-conceived heuristic, to make bad decisions. Through experiments, researchers have identified an enormous range of cognitive biases that can apply to financial decisions.
As an advisor, it’s essential to be able to point out the various kinds of cognitive biases in behavioral finance and determine how to navigate your client’s investor behavior accordingly.
Let’s look at just a few of the most common biases in behavioral finance:
1. Loss aversion
Loss aversion doesn’t mean that people would prefer to avoid losses – because that would be completely rational. Instead, loss aversion refers to having a much greater desire to avoid any risk that could bring about a loss, rather than to acquire a similar gain. An identical outcome can cause more distress, if it’s framed as a loss rather than as a missed opportunity for a gain. Shifting clients toward a positive mindset through providing successful “high risk, high reward” examples is one way to combat loss aversion bias.
2. Endowment effect
The desire to avoid losses can result in an endowment effect, where people will value an item more highly once they own it.
In one experiment, students were given either a chocolate bar or a coffee mug at the beginning of class. At the end of the class, the students were then given the chance to trade their chocolate bar for a coffee mug or vice versa. In both cases, students were relatively unwilling to trade and opted to keep the item they had been given at the beginning of class, regardless of their personal preference.
This is a classic example of the endowment effect. Once we receive something, it becomes ours. And once it becomes ours – letting go of it feels like a loss. Because of loss aversion, this feeling of loss is more painful than the offsetting gain from trading it for a new item – even if we would have initially chosen the new item.
3. Sunk cost fallacy
Have you ever bought tickets to a future occasion and then, on the day of the event, realized you no longer felt like going, but, perhaps begrudgingly, went anyway since you already paid? Because you don’t want to feel as though you wasted money, you act in ways that counter your best interests in the present day.
The sunk cost fallacy happens when you invest more money in a losing project because of previous investments. Coincidentally, the more you invest in something, the harder it becomes to abandon it. As an advisor, it’s important to work with clients and show them the bigger picture when they’re making poor investment decisions based on past expenditures.
4. Familiarity bias
The list of potential biases that can push investors away from rational investing can go on (almost) indefinitely. Investors may have a familiarity bias, where they prefer stocks in companies that they buy products from, that they work for, or where they have a family connection. Because of familiarity bias, investors may misread past or future market fluctuations thinking that they’re predictable, resulting in overconfidence.
5. Status quo bias
Status quo bias is a preference for the current state of affairs. It’s the act of avoiding change due to the risk of loss compared to the status quo reference point.
For example, individual investors tend to be much more willing to sell a stock that has gained in value, but opt to hold on to a stock that has lost value. And this occurs despite the fact that there are tax advantages to recognizing a loss and holding a gain. This emotional desire to avoid recognizing a loss results in underperformance.
Rationally speaking, the decision on whether to own a stock simply compares the current price with the expected future price and dividends. Whether the current price is higher or lower than the investor’s original purchase price is logically irrelevant. Yet, because the original purchase price becomes the reference point for the stock, it determines whether the sale “locks in” a loss or a gain.
6. Bandwagon effect
People often value a choice based on a comparison with an anchor, even if the anchor is irrelevant. Thus, a purchase can feel like a good value if it’s “discounted” from a very high sticker price, even if the sticker price was never actually its selling price. In the same vein, an investor may become displeased with his or her returns when a friend shares stories about even greater returns from a risky venture. The investor’s returns haven’t changed, but the reference point has.
Measuring one’s results using others as a reference point can lead to the bandwagon effect or herd behavior where following the crowd feels safer because it eliminates the risk of loss as compared with the reference group, even if the absolute risk is substantial.
Understanding cognitive biases to become a more effective wealth manager
In this article, you learned about the various types of cognitive biases that can stand in the way of your clients making sound financial decisions. Wealth managers who understand these biases can use them to help better manage investor confidence and steer clients back on the right path.
The content you’ve just read was adapted from the behavioral finance curriculum in the Wealth Management Certified Professional® (WMCP®) designation developed by The American College of Financial Services. If this information hits close to home in your practice, consider earning the WMCP® designation at The College to learn how to better serve your clients.