Advisers who understand the workings of human bias will be able to step in and help their clients stick with their investment plan, even when emotions might be driving them to do something, writes Simon Goldthorpe
We all like to think we make sensible decisions, but the truth is that no one is quite as rational as they believe. This becomes especially true in times like these, when we find ourselves faced with extreme and prolonged uncertainty.
While much of the world's focus was on caring for friends and family when the pandemic first took hold, for advisers, the continued stock market volatility was - and still is - a challenge, with clients understandably concerned about the value of their portfolio and long-term financial outlook.
And in times of trouble, humans are more susceptible to emotional decisions, which makes the risk of potentially dangerous knee-jerk reactions that bit higher.
Renowned psychologists Daniel Kahneman and Richard Thaler both won the Nobel Prize for Economics in recent years for demonstrating how humans are prone to biased decision-making. This increased focus on ‘behavioural finance' has seen financial advisers and planners sometimes taking on a new role of mentor or counsellor to their clients.
While we remain in these challenging times, there are four common biases advisers can look out for based on these theories.
Experts have said that humans feel the psychological pain of losing around twice as powerfully as the pleasure of gaining. It's easy to see how this relates in a financial context.
When making investment decisions, people are more likely to focus on risks over potential gains. Individuals may be unwilling to make financial decisions that represent loss, such as selling an investment that has fallen below the price at which it was purchased, even though the decision itself may be the best option.
In times like now, when there has been a loss of value, the aim for advisers is to continue keeping clients focussed on the bigger picture. Remind them that the risk profile was considered tolerable at the time of the initial investment and that downturns were built into the financial plan.
The Semmelweis Reflex
Back in the 1800s, Hungarian physician Ignaz Semmelweis observed that ‘childbed fever' could essentially be eliminated if doctors washed their hands before they assisted with childbirth.
Semmelweis expected a revolution in hospital hygiene because of his findings, but it wasn't to be. This is because his hypothesis - that there was one cause of disease that could be easily prevented - ran counter to the prevailing medical ideology, which insisted that diseases had multiple causes.
As fitting an analogy as this may seem, in investment terms, it means clients might often reject new information because it contradicts their own established beliefs. For example, someone might believe that a certain percentage of their assets must be in cash, based on their age, for no other reason than that they have always believed it.
The role of an adviser is to provide clear evidence to clients and challenge existing views and beliefs. Explain why doing things differently can be advantageous and show them the benefits of new ways of thinking.
When faced with a tricky situation, humans have a tendency towards ‘fight or flight'. From an investor perspective, those who choose to ‘fight' are likely to be those who are highly-engaged, glued to market updates and might ask for regular changes to their portfolio.
Any good financial adviser knows that their job is to encourage against this chopping and changing. Keep reminding them that there is a financial plan in place designed to take periods of volatility into account, and counsel against checking portfolio values all the time.
A familiarity bias occurs when a client only wants to invest in assets they know well. They might only want to consider FTSE shares, for example, and shy away from other assets that could drive returns, such as international shares.
One way to tackle this would be to demonstrate that a portfolio of international stocks is full of companies that clients may be familiar with. In this instance, you might look to show them that, by choosing international shares, they would be investing in companies such as Apple and Facebook, which may help to reduce anxiety.
Familiarity can also be built into your client experience. Simple touches like adding a photo to an email signature can help make clients feel more familiar with you, which in turn can help reduce any anxiety associated with using an adviser.
Those advisers who understand the workings of these theories will be able to step in and help their clients stick with their investment plan, even when emotions might be driving them to do something that may steer them away from their long-term goals.
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