Behavioral Finance: What Everyone Needs to Know

Behavioral Finance: What Everyone Needs to Know

The American College of Financial Services
July 12, 2019

Behavioral finance is a trending topic in the wealth management discussion. Understandably so––behavioral finance meshes psychology and economics to explain how investors make decisions and further identify the “why” behind every action clients take. When people consistently make undesirable financial or irrational investment choices, these are often the result of biases and heuristics.

Unconscious bias has the capability to create a detrimental effect on a client’s investment, which is why it’s crucial for advisors––specializing in financial planning and wealth management––to fully understand why clients sometimes act against their own interest.

Understanding Unconscious Bias in Decision Making

To help you better understand your clients and guide them in the right direction, you need to know and understand cognitive and emotional biases––and the different types within each––that exist in behavioral finance today. 

Cognitive Bias

Cognitive bias is an umbrella term that refers to the limitation in objective thinking that is caused by the tendency for the human brain to perceive information through a filter of personal experience and preferences. This bias is often innate and/or develops over a series of time – that being said, most clients (and even advisors) can fall prey to these biases. Below are four cognitive biases to be aware of:

  • Confirmation Bias: the tendency to process information by looking for, or interpreting, information that is consistent with one's existing beliefs. For example, if an investor fears annuities, despite the benefits they can have for retirement planning, that individual will only seek out information that confirms their distrust of annuities.

“One of the biggest problems with the world today is that we have large groups of people who will accept whatever they hear on the grapevine, just because it suits their worldview—not because it is actually true or because they have evidence to support it. The really striking thing is that it would not take much effort to establish validity in most of these cases… but people prefer reassurance to research.”

― Neil deGrasse Tyson

  • Gambler’s Fallacy: the belief that, if something happens more frequently than normal during a given period, it will happen less frequently in the future. For example, in a game of heads or tails, if the quarter lands on heads several times in a row, most people will feel inclined to bet on tails next.
  • Negativity Bias: the notion that, even when of equal intensity, things of a more negative nature have a greater effect on one's psychological state and processes than neutral or positive things.
  • Anchoring: when people rely too much on pre-existing information or the first piece of information they find when making decisions. For example, if you come across a shirt with a $1,000 price tag, and then see a second shirt that’s only $100––you’re now prone to see the second shirt as cheap.

Emotional Bias

Emotional bias is the distortion in cognition and decision making due to emotional factors. Emotional biases are often spontaneous in nature, since they are based on the personal feelings of an individual at any given time––during which––the decision is made.

  • Loss aversion: having a greater desire to avoid any risk that could bring about a loss, rather than to acquire a similar gain. An identical outcome can cause more distress, if it’s framed as a loss rather than as a missed opportunity for a gain.
  • Overconfidence: the tendency people have to be more confident in their own abilities, such as driving, teaching, or spelling, than is objectively reasonable.
  • Endowment Bias: people are more likely to retain an object they own than acquire that same object when they do not own it. For example, when an individual inherits shares from a deceased relative, even if the shares do not fit with the investor’s risk tolerance and negatively impact the portfolio’s diversification––the investor is exhibiting the endowment effect when they refuse to divest the less than optimal shares.
  • Herd behavior: the lack of individual decision making, causing people to behave in a similar fashion to those around them. It’s the FOMO (fear of missing out) of finance in which an investor gravitates towards an investment solely based on the fact that everyone around them is purchasing it.

Consider the WMCP®

Navigating behavioral finance theories and becoming an effective coach is an essential skill for financial advisors and planners. Earning a designation can also help you better understand your clients so that you can help them make sound investment decisions.

Created by a team of financial researchers at The American College, the award-winning Wealth Management Certified Professional® (WMCP®) designation is unlike any other designation. The WMCP® program is designed to teach advisors how to communicate with clients on a personal level and apply goal-based investment strategies that address a full range of goals, from education funding to future earnings potential to estate-planning and beyond. Wealth managers who understand behavioral finance are better suited to manage investor confidence and steer clients back on the right path.