5 behavioral biases that can affect your clients' ability to meet their investment goals

When we make investments, we're often guided by emotions and mental shortcuts that are rooted in behavioral biases, says Omar Aguilar, Ph.D., President, Chief Executive Officer, and Chief Investment Officer of Schwab Asset Management^®. The better financial advisors understand this problem, the more they can coach their clients to help mitigate mistakes that may knock them off course.

Here are Omar's quick thoughts on five key behavioral biases. He also shares tips on how advisors can help their clients stay focused on their goals, especially during times of market volatility.

1. Home bias

Many people like to stick with what feels comfortable, like using same brands for shampoo or investing only in their own country. This can cause them to put too much of their savings in one type of investment, limiting diversification. A common instance of home bias is when clients receive stock grants or options from their company and hold all the shares rather than selling some to rebalance their portfolios. By putting nearly all their eggs in one basket in this manner, big changes in a company's performance can significantly affect client savings.

What you can do: Sometimes clients need to be reminded of the benefits of diversification. Just as you would never recommend 90% of their assets be invested in international equities or alternative investments, help clients understand the need to right-size their allocations across opportunities so that they can better tap into the benefits associated with a diversified portfolio.

2. Overconfidence bias

More than 70% of people believe they're above-average drivers.¹ This is mathematically impossible, but it's a good example of how clients generally lean toward overconfidence.

Overconfidence bias might lead your clients to call you with "can't miss" ideas or urgent news about the markets or a hot stock. This can cause a lot of headaches, especially when these guesses don't pay off. Fortunately, your clients have you to help them avoid inappropriate risks and fundamental miscalculations.

What you can do: Introduce investing concepts and perspectives that help your clients become more objective. If they insist on a particular approach, explore historical returns together and discuss past performance results. Explain how and why results can vary over time. You can also do a "premortem." Ask clients to imagine that their strategy succeeds and all the reasons why, then have them imagine that it underperforms and the reasons for failure. This might help clients see the risks of excessive optimism and how much would have to go right for an overconfident strategy to succeed.

3. Loss aversion bias

No one likes losing, but we tend to feel losses much more acutely than wins. In fact, investors often need an extra—and sometimes significant—incentive to take financial risks that might lead to losses. This is why clients often ask their advisors to sell their stocks when the market is falling, even though history shows that's usually a bad idea in the long run.

What you can do: Walk clients through different historical downturns and map out the scenarios, showing how their portfolios would have changed based on a fear-based response versus a more balanced response of staying invested over time. You can also help clients set up guidelines and rules for buying, selling, and rebalancing. That way when their emotions run high, your clients are more likely to stick to their agreed-upon plan and less likely to make impulsive decisions that will harm their results over the long term.

4. Recency or representative bias

Say you flip a coin and get heads. What will the next flip be? Our brains look for patterns: the next flip probably will be tails, right? Or maybe heads keeps popping up? (Spoiler alert: the odds are 50/50 each and every time.)

In investing, the tendency of clients to place too much emphasis on experiences that are freshest in their memories can lead them to make investment mistakes. For example, they may want to hold on to stocks that grew quickly in the past or chase a "hot investment trend" because of expectations for further gains, even if the fundamentals suggest otherwise.

What you can do: When talking with clients, discuss the most noteworthy headlines of the day/week. Then, remind them what really matters to them and their families—their goals and the plans to reach them. Over time, they can begin to see that the day's to news story isn't necessarily pertinent to their longer-term needs.

5. Confirmation bias

We've all done it—cherry-picked information that supports a flimsy argument and ignored facts that don't fit our narrative. In investing, clients who seek out information that confirms their beliefs can twist themselves in knots just to push forward strategies that might lose them money.

There's solid research backing the widespread prevalence of confirmation bias. A study of online stock trading boards by the University of Texas measured how investors responded to messages that either supported or contracted their beliefs about a certain stock. The study found that about 85% were disposed to accepting confirming opinions. In fact, the vast majority said that messages that supported their preexisting beliefs had the widest support, were backed by news about the stock, and made the most convincing arguments.²

What you can do: Communicate! Ask clients about their investment opinions, then gather information that adds nuance to long-held beliefs. You can also set up systems that help override impulses such as trading rules and expected tolerance ranges.

The value of a clear-eyed process

These are just a few examples of the many behavioral biases that clients may have. It's hard to put biases and emotions aside when investing, especially if your future depends on the results. For some clients, decisions about their portfolios feel high stakes, which adds pressure that can do a lot of harm. Ultimately, developing a long-term plan with clients and working on ways to potentially help mitigate their biases should increase the likelihood of reaching their long-term goals.

What you can do next

• Find insights and tools to unlock the power of behavioral finance, strengthen client relationships and optimize investing outcomes. Explore our robust behavioral finance education.
• Consider a custodian that is invested in your success. Contact us to learn more about the potential benefits of a Schwab custodial relationship.