The Dow Jones Industrial Average drops 200 points in a single day, financial pundits forecast a depression, and suddenly the phones start ringing. Clients are questioning if they should sell stocks and whether it was a good idea to hire you to diversify their portfolio in the first place. It’s a familiar and frustrating scenario for many financial advisors, but a basic understanding of human psychology can help better understand client concerns and devise the appropriate responses.

In this article, we will look at how cognitive biases play into financial decision-making and ways to help clients avoid them to make better investment decisions. (For more, see: Advisors: Watch Out for Confirmation Bias.)

What Are Cognitive Biases?

Cognitive biases are tendencies to think in ways that deviate from rationality or good judgment. Some of these biases are related to the way our memory works, while others are problems with attention to detail. Cognitive biases can be roughly organized into four categories:

  1. Too much information;
  2. The limits of memory;
  3. The need to act fast;
  4. Not enough meaning.

There are hundreds of different cognitive biases that fit into these four categories, ranging from the well-known confirmation bias to the lesser-known defensive attribution hypothesis. But they all stem from the way that the human brain processes information, which happens to be exceptionally poor at data-driven financial decision-making.

Common Cognitive Biases

The good news is only a handful of biases are responsible for causing the majority of problems associated with making financial decisions. The bad news is that these biases can be extremely costly over the long run if they are not addressed by investors. The three most common investor biases are:

  • Endowment – The tendency to value assets already held more highly than similar assets that aren’t currently owned. These attitudes lead investors to hold on to underperforming assets for too long while undervaluing other investments that are potentially better.
  • Loss Aversion – The preference for not losing money over achieving an equivalent gain in capital. These preferences lead investors to be too conservative and hold depressed assets with the belief that unrecognized losses are better than recognized ones.
  • Confirmation – The tendency to focus on evidence that confirms existing beliefs. These make it difficult for investors to adapt to market changes and recognize new opportunities, while finding false comfort in their prior convictions.

The impact of these cognitive biases on investor performance is striking. According to Morningstar, poor timing has led investors to underperform diversified returns for U.S. stock funds by 1.8% per year for the past decade. A similar DALBAR survey found that poor timing was a key contributor to lagging returns for stock mutual fund investors – almost 4% during the past two decades – costing billions of dollars in returns. (For more, see: Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias.)

Tips for Managing Clients

The most important thing financial advisors can do is to keep clients focused on the long-term and limit their exposure to these cognitive biases. A good starting point is to assess a new client’s risk tolerance and return expectations and use them as a basis for planning. During the assessment, it is helpful to show clients the interplay between risk and return to help them understand how a low-risk portfolio might underperform the market. It may also be helpful to show estimated deviations for a given portfolio to help them understand that some losses are expected, but the long-term trend remains higher.

Advisors may also want to consider creating a verbal or written "contract"for a portfolio strategy that helps the client acknowledge risks and rewards, as well as a plan to regularly contribute regardless of market performance at the time. If the stock market drops, advisors can recall or point to the agreement as a way to reassure clients that everything is on track despite the perceived increase in risk.

These two strategies can help clients avoid the most common cognitive biases associated with investment decision-making and ultimately improve long-term performance.

The Bottom Line

Cognitive biases are highly prevalent across all kinds of decision-making processes, but financial decisions are particularly prevalent and costly for clients. Financial advisors can help clients avoid these mistakes by creating a plan of action from the onset and keeping them focused on the long-term rather than short-term fluctuations. By doing so, advisors can maximize returns for clients while improving their own fee income. (For more, see: How Advisors Can Help Clients Stomach Volatility.)

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