We take a look at some common behavioral biases, how they can affect the advisor-client relationship, and some strategies for overcoming them.
At Nasdaq Dorsey Wright we are big proponents of rules-based investing and every strategy and model on the platform is underpinned by a quantitative rules-based system. Matrix models buy a stock when its rank is above X and sell it if drops below Y. Relative strength (RS) switching models buy stocks or funds that are in a column of Xs against the benchmark and sell them if they reverse into Os. The model doesn’t question the merits of a position that’s being added or sold, it simply follows the rules and makes the prescribed trade. While every trade a model makes won’t be winner, we’ve found that, over time, if we take a hands-off approach and let the process work, the magnitude of the gains from winning trades far exceed the losses.
Most people consider themselves to be rational but there is a lot of evidence to suggest that we routinely make irrational decisions. Our inclination towards systematic investing isn’t born out of a general love for rules. It stems from the fact that in investing, emotions can be a major hindrance even to seasoned professionals.
As Richard Thaler, one of the founding fathers of behavioral finance and 2017 winner of the Nobel Prize for Economics put it:
“Conventional economics assumes that people are highly rational – super-rational – and unemotional. They can calculate like a computer and have no self-control problems.”
But, because of cognitive and emotional biases, people behave irrationally quite often. At a macro level, this irrationality can impact things like global inflation. On a micro level, it affects our individual investment decisions.
One of the most important facets of the advisor’s role is to help clients maintain perspective and stick to the plan you both have developed together. As a result, the effects cognitive and emotional biases have on individual investor behavior have important implications for the advisor-client relationship. Understanding these pitfalls and their effects can help you understand your clients’ impulses and help you keep them on course, ultimately making you a more effective advisor.
Even if you didn’t realize it at the time, you’ve almost certainly encountered clients exhibiting cognitive or emotional biases. Perhaps you’ve had a client who refuses to believe that the Ford (F) stock they purchased 20 years ago is no longer a good investment because they love their Mustang. Or maybe it’s a client who refuses to sell any of their employer’s stock because they believe they have some control over the stock’s performance. A few of the emotional and cognitive biases you may encounter (or may have already encountered) are outlined below.
Emotional Biases:
Loss-aversion bias – put simply, loss-aversion bias is a preference for avoiding losses over making gains. Loss-aversion can cause clients to hold on to losers for too long and to sell winners too quickly.
Regret-aversion bias – clients exhibiting regret-aversion bias are apt to avoid making decisions out of fear that their decisions will turn out badly. Regret-aversion can lead to herding behavior – clients may gravitate to investments that are popular because they feel safer among the crowd. If everyone is wrong about a stock, they will feel less personally responsible for making a bad decision.
Endowment bias – a phenomenon Richard Thaler has studied extensively; endowment bias occurs when a client places a higher value on assets they own (i.e. the price they require to sell a stock they own is higher than the price they would be willing to pay for the same stock). Endowment bias may make clients reluctant to sell certain assets and also result in suboptimal asset allocation.
Cognitive Biases:
Mental accounting bias – another bias studied by Thaler. A client exhibits mental accounting bias by mentally assigning money to different categories or “buckets” and treating it differently based upon that assignment. Mental accounting bias can also result in a suboptimal asset allocation.
Confirmation bias – this bias occurs when clients seek out and give credence to information that confirms their existing beliefs. Confirmation bias may cause clients to consider only the positive information about an investment and ignore new information that would contradict their investment thesis. Confirmation bias can result in clients not considering all available, relevant information about their investments.
Hindsight bias – a client showing hindsight bias will often see past events as having been predictable. Hindsight bias may lead clients to overestimate the extent to which they predicted investment results causing them to become overconfident.
Educating your clients is an important aspect of overcoming their biases. For example, you might overcome a client’s mental accounting bias by discussing the fungibility of money and showing them how mentally dividing their assets into separate accounts or “buckets” is preventing them from achieving an optimal asset allocation. Education is typically more successful in overcoming cognitive biases than emotional biases.
Removing emotion from the equation is one of the major strengths of rules-based investment strategies and is another tool that you may find effective in keeping your clients on the right path. DWA offers many such strategies that you can tailor to meet the individual needs of your clients.
Think about an investor who suffers from loss-aversion bias – always holding on to their losers for too long and selling their winners too soon. They could benefit from a matrix model that holds onto any position that is maintaining strength and quickly and systematically culls positions exhibiting weakness. A relative strength/rules-based approach could also benefit an investor with regret-aversion and who only wants to own “popular” stocks. In fact, there are few emotional or cognitive biases that couldn’t be mitigated or remedied by adopting (and adhering to) a rules-based system.
