Although the study of Economics is considered a science and has many undoubted truths, the art of investing is not something easily mastered. For this reason, clients who invest often are burdened with uncertainty and make irrational decisions based on emotion. This white paper discusses six factors that affect clients’ ultimate decision when entering the investing world. The six are: Loss aversion, anchoring, familiarity bias, mental accounting, the gambler’s fallacy, and herd behavior.
Loss Aversion: One of the biggest problems that clients run into when investing is that the feeling of losing their investment greatly outweighs the joy of succeeding. In fact, a loss hurts about 2.25 times more than the equivalent gain according to Daniel Kahnemann, expert on behavioral finance. Given this, advisers must understand that any measurement of risk tolerance should not be considered 100 percent effective. In some situations, investors may become so frightened by market failures that they hold onto investments that seem safe, even though the seemingly “riskier” investments may give them less of a risk. For an adviser to combat the issue of loss aversion, first and most importantly, they should take every opportunity of client contact to ensuring their clients that they care deeply about their financial success and that they are well versed in the art of investing so that they can help their clients meet their goals. Simply said, trust is key. Another important thing to mention to clients, is that it is part of an adviser’s job to show their clients possible risk, no matter how unpleasant this may be to them. Clients must be aware that regardless of positive economic forecasts, stocks can still go down as well as up. Therefore, advisers must get clients to understand that a loss in investment will not always terminate their long-term goals. Honesty when dealing with these awkward economic questions is important to building a solid foundational trust with the client. This will also help clients focus on their long-term investing goals instead of how well the market is doing currently.
Anchoring: This is the human tendency to focus on one piece of information when making a decision. Anchoring can cause the investor’s assumption on security prices and the future of these prices to be unsound. An example of anchoring can be seen when a stock is being traded at a price range of $20-$25 so the investor believes that the stock is worth about $22. However, it’s just as rational or irrational to believe that the stock is really worth $15, but has been selling higher for a short while. This is a problem for their long-term investment as they may be unwilling to sell the stock for $15 as their anchored opinion is that the stock is really worth that $22 a share. Tying the purchase of a security to a purpose is a good way to help investors with their anchoring problem. For example, if a stock is purchased for its dividends, remind clients that a stock price decline does not affect the dividend-paying ability of the issuer. Setting pre-determined buy and sell targets is another way to solve anchoring. This can help to sell winning stocks later and losing stocks sooner
Familiarity bias: It is a human tendency to come to conclusions too quickly based on past experiences. When dealing with problems that have completely different variables and facts, people often look for similar experiences to help them make decisions. This can often lead them in the wrong direction. American investors tend to put too much emphasis on U.S. issues because we are familiar with them. Also, investors often invest in the markets that they are comfortable with over new markets that have promising outlooks, just because comfort trumps their decision making process. In order to deal with this problem, advisers should use stories from their experiences to help their clients feel comfortable with new investment opportunities. To help make foreign companies more familiar, advisers should remind clients that huge U.S. brands are often controlled by foreign companies. U.S. institutional investing often ignore borders among developed countries. Clients must be reminded of that.
Mental Accounting: This is the mental operations we use to organize and evaluate financial activities. For example, someone who earns both a salary and a bonus may compartmentalize this into one used for certain types of daily finances and the other as a way to pay for other equally important or leisurely finances. This causes the average person to view the dollar differently in one context as opposed to the other. Advisers should help their clients think about all their money in a more rational way, which in turn can help their financial decisions as well. A strong example of this is expressed in the white papers: “If a client is paying credit card interest at 18 percent or more…eliminating that debt by tapping money in a checking account or a money market fund earning 0.2 percent can represent a return of more than 17 percent.” Also, clients who enjoy the thrill of stock trading, even though it might hinder long-term financial goals can be properly dealt with by the adviser. This can be done by allocating a small amount of their client’s currency to this trading in order to keep clients content while also protecting their assets.
Gambler’s Fallacy: This fallacy is caused by past results affecting future odds. Humans have an issue with the mathematics of probability. We often see patterns in random events and then after realizing the pattern, believing that it cannot continue. People who believe that decreasing stocks are bound to increase eventually, fall victim to the fallacy. Advisers must constantly remind their investing clients that every day is a new day with new variables and outcomes. Past patterns are not always sure indications of future short-term results. Advisers also find that reminding clients of their long-term goals and tracking their progress is an effective way of warding them away from gambler’s fallacy.
Herd Behavior: This behavior can be linked with a term called bulled territory; when social pressure mounts to join what seems to be winning behavior. “Everyone’s doing it and making money, so it must be right.” Rising stock prices often lead to wildly excessive valuations and ultimately a collapse in price, leading to a very poor investment decision. The best way for advisers to steer clients away from herds is to educate and remind clients that understanding valuations, and paying and receiving a reasonable price for securities based on value is the best way to achieve short and long term goals. Also, it is important to let clients know that if their friends and family and investing in a stock that seems promising, make sure to let their adviser know prior to making any rash investing decisions.
I want to thank Robert Strand for his work on this article. He is a student at Penn State University seeking a B.S. in Economics. Caderat Grant’s recent white paper on this topic was used as our background and it is available here: http://www.investmentnews.com/dcce/20150529/4/4/WP_SPONSORED/3268305
Securities offered through Triad Advisors, Member FINRA / SIPC. Advisory Services offered through Planning Solutions Group, LLC. Planning Solutions Group, LLC is not affiliated with Triad Advisors. PSG Clarity is a division of Planning Solutions Group, LLC