One of the key tasks for financial advisors is to help clients avoid behavioral biases which may impact their ability to reach long-term objectives, or which could lead to a loss of wealth. Behavioral biases can be classified into two types: cognitive shortcuts and emotions. Cognitive shortcuts are errors in how investors process information. Emotions are errors arising from how investors feel about a situation.
Table 1 below lists some common cognitive shortcuts and emotions with some examples of how they may impact an investor’s decision-making. Left unchecked, these biases can contribute to decisions that can negatively impact investors’ long-term goals.
So how should financial advisors address biases in investment decision-making?
There are two choices: Accommodate or educate.
Accommodating involves constructing an investment strategy which takes an investor’s behavioral tendencies into account. An example of this would be constructing a portfolio with a higher allocation to U.S. stocks than the market capitalization weight for a client who prefers investing domestically (i.e. home bias).
Educating involves providing investors the information they need to overcome the bias they may be exhibiting, such as teaching a client with a strong home bias about the diversification benefits of investing internationally.
Whether to accommodate or educate depends on the type of behavioral bias. Investors exhibiting cognitive shortcuts may be best served by attempting to moderate the cognitive error through education to reframe the biased thinking. Investors exhibiting emotions, on the other hand, may not respond to education and may require some concessions for them to become more comfortable with the investment strategy — in other words, their emotional bias should be accommodated.
The investor’s relative wealth level also helps determine whether an investor should be educated or accommodated when formulating an investment strategy. Clients with higher levels of relative wealth, and therefore lower levels of risk to their standard of living, can afford to bear the consequences of the behavioral biases they exhibit. A relatively wealthy investor exhibiting illusion of control bias (see Table 1) may be permitted to allocate a small allocation to an active manager as part of a “core and explore” strategy, provided the allocation isn’t large enough to impact the client’s long-term objectives.
Clients with lower relative wealth levels, translating to higher levels of risk to their standard of living, may need more education to moderate the consequences associated with their behavioral biases. Table 2 below helps illustrate the intersection of behavioral biases and standard of living risk. However, an advisor’s decision to accommodate or educate may be thought of as occurring on spectrum rather than a clear black or white rule; at times, both approaches may be effective for the same client.
Behavioral biases and standard of living risk change over time, so regularly evaluating investors’ behavioral biases is key to implementing a long-term investment strategy. Studies, including DALBAR’s Quantitative Analysis of Investor Behavior, have repeatedly shown us the consequences of poor investor behavior. Succumbing to behavioral biases can derail the best-laid plans.