Behavioral Finance: Six Preconceptions Your Clients Need to Let Go Of

Behavioral Finance: Six Preconceptions Your Clients Need to Let Go Of

The American College of Financial Services
January 23, 2020

As a financial advisor in charge of giving sound advice to people about how to manage their money and resources, it can be frustrating to see clients making poor decisions--especially when you know those decisions are based on less than accurate information. The truth is that all of us, each and every day, make choices largely based on preconceived notions that don’t actually have any basis in fact: we just like the way they feel. In behavioral finance and elsewhere, this phenomenon is called “cognitive bias.” When ill-informed opinions start to shape decisions that can affect your future, it’s wise to take a step back and reconsider. For financial services professionals, getting your clients to overcome their biases and think outside the box can be the difference between success and failure.

Since the New Year is all about letting go of preconceived notions and things that no longer serve you, here are a few of the most common cognitive biases you may experience when dealing with clients, as well as what you can do to address them.

 

#1: Losses are Bad

 

As with all cognitive biases, the idea that loss is a bad thing seems eminently reasonable at first. Having more of something is better than having less of something, especially when that something is money. However, an irrational fear of taking losses can lead to a common problem in behavioral finance known as “risk aversion.” A risk-averse client is someone who is unwilling to take any kind of risk in pursuit of bettering their financial situation, and as such avoids big potential gains in favor of much smaller growth with less risk.

Of course, any kind of investment is inherently a risk, subject to the ups and downs of financial markets, and while seeking to minimize risk isn’t always a bad thing, too much risk aversion can paralyze decision-making and eliminate potentially life-changing opportunities. Addressing risk aversion has a lot to do with promoting a positive mindset with your clients. Use examples of successful high risk, high reward scenarios to show them what’s possible, and if they miss out on something or an investment takes a dip, reframe it as “missed opportunity” rather than just a loss. This will build your clients’ confidence in taking risks and help them rest easier in your hands.

 

#2: Don’t Rock the Boat

 

While we spend a lot of time talking about change, making resolutions, and promising ourselves and others that we will alter our behavior, most people naturally prefer the status quo: a situation where things stay the way they are. We pay a lot of lip service to change, but in reality, change can be a scary thing, and it’s often much easier to stick with what you have now than consider what you potentially could have if you did something different. This is called “status quo bias,” and it applies to behavioral finance in terms of stocks and investments. For example, overall investors tend to be much more willing to sell a stock that has gained value since its initial purchase than one that has lost value. The logic here is that if something goes up, cash in. If it goes down, rather than acknowledge a loss or that you might have made a mistake, stick with it in the hopes that it will regain value in the future. This flawed concept results in many clients keeping bad investments much longer than they should.

Work with your clients to promote an open mindset, one that celebrates gains but that accepts that sometimes, things won’t go according to plan and the best thing to do may be to take a short-term loss and drop a toxic investment. Also, make sure your clients understand that the real value of investments or stocks come from comparing current prices with expected dividends far into the future. Whether an asset’s price currently is higher or lower than the original purchase price is irrelevant, so don’t let original price become a false benchmark for losses or gains.

 

#3: If You Buy It, You Own It

 

It’s happened to everyone: you and a bunch of friends bought tickets to a rowdy rock concert by one of your favorite bands months ago, but when the day of the event finally arrives, you realize you don’t really want to go. Maybe you’re not feeling well. Maybe you only did it because your friends pushed you to. Whatever the reason, you convince yourself to go anyway because hey, you already paid for it, so you might as well.

Nobody wants to feel like they wasted their money on something, and in the investment world, just like everyday life, this can lead to people making decisions out of a sense of obligation that are against their best interests. It’s called the “sunk cost fallacy,” and it can stop them from ditching a bad investment even when it’s clear it’s not working for them. As a financial advisor, it’s important to work with your clients to help them see the bigger picture and avoid piling bad decisions on bad decisions. Everyone makes mistakes, and most of them can be undone provided you act quickly and don’t get that dug-in mentality.

 

#4: Hold On to What You Have, No Matter What

 

In a classic social experiment at Duke University, professors called winners and losers of a ticket lottery for one of the school’s basketball games and asked how much it would take to get them to sell their ticket or how much they’d be willing to pay to buy one, respectively. The results were stratospheric: the winners on average were only willing to sell their ticket for 14 times what it was actually worth (around $2,400), while the losers wouldn’t spend more than $200 for their own. This is an example of the “endowment effect”: as humans, we naturally don’t value something as much until we actually own it. Once we do, we’re far more reluctant to give it up, regardless of whether or not we really need it.

Having clients who are afraid of losses and risk-averse can lead to this endowment effect. If a client has a stake in an investment, they may be unwilling to let it go, even if you present them with evidence that it’s not a good long-term decision for them. An entrenched sense of endowment can be a difficult habit to break, but one way to start is by setting concrete rules with your clients for investing and establishing a known system that is governed by simple math. If an investment isn’t working and there’s another that could be better, it’s time for a change. Numbers don’t lie.

 

#5: Go With What You Know

 

Similar to the status quo bias is the “familiarity bias,” a result of humans’ natural tendency to seek comfort in the familiar. In search of a sure thing to hitch their financial futures to, some investors prefer to buy stock in companies they have connections in, or that they buy products from regularly. But just because you enjoy a certain brand of coffee or a type of computer doesn’t mean it’s a good long-term investment.

Too much familiarity can cause investors to misread past or future fluctuations in the market because they trust a brand or they think such changes are predictable when they’re not. This overconfidence can lead to poor decision-making that, as a financial advisor, you should seek to steer clients away from. Encourage your clients to think outside the box when investing and consider stock in companies they may never have considered before, but that have demonstrated or theoretical growth potential. You’re much more likely to have long-term success if you diversify and get clients out of their comfort zones.

 

#6: You’ve Got to Keep Up with the Jonses

 

Humans are hard-wired to want to believe we’re the best at what we do--that we’re smart, successful, and “ahead.” If you see your neighbor get a fancy new car, one of your first reactions might be envy or jealousy that someone else has something you don’t have. You feel inadequate because you don’t have that same nice car, and wonder what you’re doing wrong. This means that if a whole lot of people are doing something and seem to be happier for it, we’re much more likely than not to go along with what they’re doing so we can get some benefit out of it for ourselves--it’s how trends or fads get started.

We measure our success, rightly or wrongly, by using others around us as a reference point. This leads to herd behavior, where following the crowd feels safer because it eliminates the risk of loss, also known as jumping on the bandwagon or the “bandwagon effect.” In the financial services, a client may be dissatisfied with their returns when they hear someone else talk about even greater returns from a risky venture and want to follow their example, regardless of how ill-advised it might be. As a wealth manager, you need to come to these conversations armed with information and prepared to demonstrate why certain popular trends might not be as good as they seem at first. Remind your clients of their own stable returns and continued growth, and don’t let them get distracted by irrelevant reference points.

 

By understanding these and other cognitive biases in behavioral finance, you can become a better financial advisor and more trusted and successful wealth manager. Consider the Wealth Management Certified Professional® (WMCP®) designation developed by The American College of Financial Services to learn how you can keep your clients’ confidence and steer them back on the right path.

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