Behind the biases: 5 tips for coaching investors toward better decisions
The human brain is not wired to be great at investing, says behavioral economist Jay Mooreland, founder of The Emotional Investor. The more financial advisors understand this—and see how emotions and mental shortcuts are rooted in the following biases—the more they can coach clients to avoid mistakes that may knock them off course.
Here, Mooreland offers his perspective on five key behavioral biases, and tips for advisors on how this understanding can help their clients stay focused on their goals—particularly in times of market volatility.
Recency or representative bias
Say you flip a coin and get heads. Will the next flip be heads or tails? Our brains look for a pattern: The next flip probably will be tails, right? Or maybe heads is on a roll? (Spoiler alert: The odds are 50/50 no matter how many coins you flip.) This bias can lead clients to assume an underperforming investment either will keep lagging or is due for a bounce.
What you can do: Give clients tangible evidence that short-term returns are unpredictable. At each meeting, consider asking clients if the market will rise or fall over the next month, and whether the gain or loss will be more or less than 5 percent. Track the (in)accuracy of their answers, and report back to the clients from meeting to meeting.
People often judge decisions based on how they turn out, not how sound they were. Say you put a client's assets in a long-term holding just before it starts to lag the market. Does that make the decision a bad one? Of course not—but it might feel that way to the client.
What you can do: Your clients may want to talk about the performance of each of their investments compared to market indices. And it's okay to indulge that curiosity. But work to focus the performance conversation more on clients' progress toward their goals, not on whether they're beating or lagging market indices.
Our brains tend to get attached to a particular number, even an irrelevant one. That phenomenon can cause investors to behave irrationally—for example, if they read a story about an investor who earned 10 percent annually, they might anchor on that number and expect unrealistic returns.
What you can do: Bring this bias to life by telling clients that the stock market has averaged a return of more than 8 percent a year. Then ask what range of returns they'd expect over the next 12 months. Anchored to eight and 12, they'll probably name two positive numbers—even if they know that stocks sometimes suffer steep losses. Reset their expectations using market history.
This is the tendency to make judgments based on the pieces of information we think are most important—even if they're not. It's a big problem these days, as clients are constantly bombarded with fast-changing headlines from financial media.
People often predict future outcomes with great certainty, even when it's impossible to accurately predict that outcome. It's a shortcut our brains use to deal with uncertainty—if Outcome A happened in the past, then it should happen again in similar circumstances. But as we all know, past performance doesn't guarantee future results.
What you can do: Use some specific stock market downturns to show clients the effects of hindsight bias in action. In the aftermath of recent stock market slides, many investors claim to have seen the crash coming. But in reality, few investors accurately predicted the bursting of the dot-com bubble in 2000 or the precipitous decline in 2009.
What you can do next
- Help your clients identify and manage their investing biases with the Biagnostics® Toolkit at schwabfunds.com/biagnostics.
- If you're thinking about becoming an independent advisor, consider a custodian that invests in your success. Contact us to learn more about the benefits of a custodial relationship with Schwab.
About Jay Mooreland
As the founder of The Emotional Investor, behavioral economist Jay Mooreland helps financial professionals and the investing public understand the drivers behind biases and decision-making. He is a CERTIFIED FINANCIAL PLANNER™ professional who speaks internationally about investor behavior and offers seminars that explain how to improve decision-making behaviors and processes. In addition to authoring The Emotional Investor: How Biases Influence Investment Decisions … and What You Can Do About It, Mooreland has published several articles in industry journals, such as the Journal of Financial Planning, and authored "The Irrational Investor's Risk Profile," which explains why investors often say one thing and do another.