The field of behavioral finance attempts to describe what most of us know intuitively – people do not always make rational choices. Why not? It’s part of being human. The shortcuts that our brains are wired to make may have enabled our physical survival, but these same cognitive processes can lead clients to make poorer financial decisions.
Where financial decision-making is concerned, it’s best not to let emotions influence actions and approach decisions logically. Advisors who understand common patterns of faulty reasoning known as cognitive biases can guard clients and nullify the negative influence of these habitual patterns of thought.
Keep clients on the right path by helping them understand how their biases work and taking time to explain the logic behind recommendations or strategies. When clients understand (and anticipate) common cognitive biases, they increase the probability of making better, more informed financial choices.
Review these common biases below (listed in no particular order) and the roles they play in influencing clients’ approaches to making decisions.
1. Anchoring and adjustment bias is when clients fixate on a target value – usually the first one they see. Individuals then make new decisions based on the old, anchor number. Anchoring numbers can come from forecasting tools or an outside advisor. Once the client begins making new decisions based on the old, anchor number, it can lead them to errors
2. Framing bias is when clients react to a particular issue or opportunity based on whether it is presented as a loss or as a gain. In this situation, clients faced with the threat of a loss, may feel it more deeply than the promise of an equivalent gain. Clients will often seek to avoid a risk when a positive frame is presented but seek risk when a negative frame is offered.
3. Representativeness bias is the degree to which clients will judge the effects of an event based on their similarity to other events. But, assuming one can forecast events based on their likeness to other events is an error. Clients overestimate their ability to predict the outcome of events.
4. Availability bias links the probability of events to how easily or quickly examples come to mind. The more memories clients can recall about certain events, the more important the memories seem. Old memories that come to mind quickly are judged to have more weight when making judgments than more recent events that may be more accurate.
5. Confirmation bias is the common tendency to search for and interpret information in a way that confirms pre-existing beliefs. When clients gather or remember information selectively, they are exhibiting this bias. The effect of this bias is strongest for emotionally charged issues and deep beliefs.
6. Overconfidence bias is when a client’s confidence in their judgments is greater than the actual objective accuracy of their judgments. Some clients will express strong certainty in the accuracy of their beliefs, even when this confidence is not warranted. People believe they are correct more often than they should or can be.
7. Hindsight bias (also called the “knew-it-all-along” effect) is the tendency of clients to see an event as having been predictable after it occurs, even when there was no way to predict it. The mind reorganizes content to support the ultimate outcome as it occurred so this bias also distorts memory.
8. Gambler’s fallacy is the notion that something that has recently happened frequently will be less likely to happen as frequently in the future. The reality is that situations that are truly random cannot be predicted.
9. Endowment effect refers to the tendency of clients to demand much more to give up a possession or material object than they would agree to pay if they had to acquire it in the marketplace at current value.
10. Disposition effect is the bias where clients will want to sell an asset that has increased in value and be reluctant to sell an asset whose value has decreased.
The phrase, “He who does not understand history is doomed to repeat it,” is certainly true where cognitive biases are concerned. When advisors educate clients to recognize biases, clients may become better at recognizing when they are acting under the influence of these irrational shortcuts.
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