People make financial decisions based on emotion and biases. I am sure that you are not surprised to hear that. As a matter of fact, you probably experience it every day. As an example, say you are working with a client regarding their investment portfolio and due to something that they heard on the news or through a colleague, they are ready to jump ship on an investment that you recommended. Or you suggest that a client increase their allocation of equities to combat long-term inflation but, due to a Google search on “inflation,” they argue that inflation has been around 2% for several years. These are examples of how behavioral finance plays out in our field.

The concept of behavioral finance has been around for over 30 years. However, the focus has been largely on how the consumer handles issues. I’d like to put some perspective on how advisors may fall prey to these same biases when dealing with clients. (For related reading, see: Effects of Behavioral Biases in Investing Decisions.)

Bounded Rationality

Bounded rationality is one element of behavioral finance. It’s the idea that we can be influenced by constraints on information, cognitive ability and time. It is a bias that affects most advisors whether they accept it or not. With all of the information available to us, it is difficult to sift through all of the stock analyst reports, mutual fund data, company financial statements and the proliferation of content available on the Internet.

In the perfect world, we have all of the information that we need to make an informed recommendation to our clients, but in reality, this is truly not the case. As confident as we are in our brilliance as “financial experts,” there is always someone smarter and always those who are able to focus on a specific investment at a time to learn its nuances. In a perfect world, we would not be constrained by time to gather and analyze information and make optimal decisions.

But we don’t operate in a perfect world. So what do we do? We make the best decisions that we can based on the resources that are available to us, which may include using problem-solving shortcuts that give us the confidence to “pull the trigger” on making those decision. According to Gerry Herbison (assistant professor at The American College), a result of bounded rationality is “satisficing,” which is the concept of “good enough” in decision making.

In optimal decision making, the decision maker is convinced that there is no other better option. Satisficing decision maker(s) may not have enough information, time, or the capacity to make the “best” decision. The decision becomes the best option available, given the information, time and decision maker capacity. Decision makers may know there is an optimal choice, but they satisfice due to the constraints. However, making decisions based on time-saving shortcuts or workarounds can often lead to suboptimal results. Since this is indeed our reality, we need to be cognizant of this as we work with clients. (For more, see: 4 Behavioral Biases and How to Avoid Them.)

Overconfidence and Overoptimism

Two other biases that most advisors are guilty of are overconfidence (the belief that they can affect events more than they actually can) and overoptimism (the belief that they are less likely to fail or are more likely to succeed than another individual). Statistically speaking, everyone cannot be above average, but the combination of these two biases allow our egos to run amok. Granted, in most cases, we know more than our clients but we can get in our own way and do irreparable damage to our clients if we never take the time to get a second opinion on the recommendations that we are making.

Herding

Herding (following the leader) is yet another bias that we take on when a new IPO comes out or a new living benefit rider for an insurance/annuity product becomes available. Although we never deliberately choose to be irresponsible, we must learn to manage our emotions, do our due diligence and understand the objectives and/or curtail the emotions of our clients.

Irrational Exuberance

Irrational exuberance (trusting your gut instincts) is a behavioral response that has put many professional athletes in their respective halls of fame. However, financial advisors don’t have the luxury of operating this way when their client’s financial security is at stake. We must operate based on the best research available to us and cross-reference it against the client’s objectives, time horizon and risk tolerance.

Framing

Finally, there is the bias of framing. At its core, framing is how we say things to a client. It is well documented that the perception of a problem not only depends on its presentation but also on the mindset of the decision maker. As advisors, we encounter people on an emotional roller-coaster as it pertains to achieving financial security. While retirement may be important to all clients, the level of importance may tend to increase with age. College funding may not be important to every client, but those with teenage children feel the pressure of planning. Insurance is rarely at the top of any client’s list, but when faced with their own mortality or that of their loved one, a shift in attention occurs.

We have the opportunity to be our client’s greatest guide or worst deceiver based on our presentation of recommendations. Since no two clients are alike, it is critical that we as advisors hone our skills at presenting relevant information in different ways because we know that something said will be received differently by different clients. (For more from this author, see: Advisors: How to Explain the Fiduciary Rule to Your Clients.)

C.W. Copeland, Ph.D. is Assistant Professor of Insurance at The American College of Financial Services, a non-profit, accredited, degree-granting institution in Bryn Mawr, PA that has educated one in five practicing financial advisers in the U.S.

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