In today’s fast-paced world, investors face a constant influx of information, from economic shifts to political updates, market analyses and investment recommendations. Amid this continuous stream of data, one essential but often underestimated aspect shapes our investment choices profoundly – human biases. As financial advisors, recognizing and addressing these biases is a crucial element in cultivating strong, trusting relationships with our clients.
The field of behavioral finance has shed light on the psychological underpinnings of these biases. However, clients frequently remain unaware of how their biases influence their investment strategies and decisions. Bridging this gap requires identifying and addressing these biases. Here, we discuss five prominent biases and explore practical strategies for advisors to effectively handle them.
The Biases Impacting Investment Decisions
Trend bias: seeing patterns in the noise. One of the most influential biases is trend bias, which stems from our natural inclination to identify patterns, assign them unwarranted importance, and believe they are valid indicators. For instance, according to the Investment Company Institute, over 90% of fund-owning households cited historical performance as a consideration when choosing funds, with 45% rating historical performance as very important.
Reliance on past performance often leads to suboptimal outcomes. It’s crucial to guide clients away from trend-based thinking, instead emphasizing a more comprehensive strategy that takes into account long-term goals and diversification.
Narrative bias: constructing stories from sparse facts. The narrative bias causes investors to interpret information as part of a larger story or pattern, even when facts do not fully support the narrative. This can lead investors to replace facts with a compelling “story.” For example, investors might latch onto a narrative about a company from the local paper or a trusted friend, disregarding the fundamentals.
Advisors must help clients differentiate between narratives and solid investment fundamentals, preventing them from making emotionally driven decisions based on incomplete stories.
Self-serving bias: taking credit for success, avoiding blame for failure. The self-serving bias occurs when individuals attribute positive events and successes to their own character or actions but blame negative outcomes on external factors. This bias can manifest when investors attribute their portfolio’s successes solely to their skill and decisions while attributing failures to unforeseen market events. Advisors should encourage clients to adopt a more objective view of their investment decisions, fostering a learning mindset and promoting accountability for their choices.
Narrow framing bias: ignoring the bigger picture. Narrow framing bias involves making decisions about parts of an investment portfolio without considering their impact on the overall portfolio. It often leads investors to make emotional and myopic decisions. For example, clients commonly become fixated on a few individual securities’ performance without considering their portfolio’s broader context. Advisors must guide clients to a holistic view of their portfolio, ensuring that individual decisions align with the broader investment strategy.
Action bias: the urge to act, regardless of evidence. The action bias is our tendency to favor action over inaction, even when there’s no evidence that action produces better outcomes. Combined with other biases, this can lead clients to try and solve non-existent problems, potentially harming their portfolios. For instance, a client who sees a CEO on CNBC might feel compelled to invest in that company without a solid rationale. Advisors should help clients understand that sometimes inaction is the wisest course, steering them away from impulsive decisions driven by the need for action.
The Advisor’s Role: Charting A Course For Long-Term Stability
As financial advisors, it’s our job to bring clarity to the complex world of investing, steering clients through their biases with support and understanding, not judgment. Amid a constant stream of financial updates and market fluctuations, it’s all too easy for clients to stray from their long-term goals.
Our role is to be a stabilizing force, providing clear insights that help clients make choices with an eye on the future, not just the near term. It’s about working with them to understand the roots of these biases and gently guiding them toward making decisions with a clear focus on the future, rather than in reaction to the present moment’s uncertainties.
Such interactions should be collaborative, aiming to create a space where clients feel comfortable and engaged. Regular strategy sessions are key to fine-tuning clients’ investment plans, ensuring they stay responsive to life’s changes while keeping sight of their future financial well-being. In these sessions, we emphasize the merits of a steady hand and the importance of not making hasty decisions based on the market’s gyrations. By nurturing patience and discipline, we can convert potential biases into teachable moments and growth opportunities.
The foundation of our advisory practice is the trust we build with clients, which turns our professional relationship into a real partnership. With a foundation of empathy and respect, we navigate the investment landscape together – avoiding potential hazards and celebrating milestones along the way. Connecting every financial decision to their larger life goals and providing advice rooted in time-tested fundamentals, we can empower clients to make informed, principled financial choices that shape a legacy of financial stability and success.
Mark Pearson is Founder and CEO of Nepsis, a national financial advisor and investment management firm.