Using Behavioral Finance to Manage Investor Perceptions

Using Behavioral Finance to Manage Investor Perceptions

New research offers important insights about investor perceptions and biases. Advisors who understand these perceptions are better able to steer their clients in the right direction and ensure their long-term success.

Financial advisors are constantly employing new strategies and techniques to better serve their clients and set expectations. To that end, one concept that is gaining considerable traction is behavioral finance, which provides a number of important insights into common investor behavior and perceptions. Advisors who understand these behavior patterns can better direct and serve their clients.

Here are some of the main lessons gleaned from behavioral finance, as well as specific tactics advisors can use to keep their clients on the right track.

 

Perception is reality for investors

It is paramount for advisors to understand the various perceptions their clients hold about the market and their portfolio performance, and how those perceptions influence their investing behavior. Research shows that investors react in predictable ways regarding their portfolios, and most often, these reactions are inaccurate or lack proper context. That’s why it is important for advisors to provide additional context so that their clients make financial decisions based on long-term goals, and not based on an immediate emotional reaction.

 

Frame the conversation

A financial advisor can ensure their clients possess the proper context and don’t succumb to emotionally driven investing by proactively framing the conversation as accurately as possible. The way a client responds to a potential investment opportunity can vary widely depending on how it is presented. Take the example of playing the lottery. Players are more likely to react positively if they are told they have a 1 in a million chance of winning, as opposed to a 999,999 in a million chance of losing. This simple example illustrates how the same information can produce vastly different responses depending on how it’s framed.

Framing the conversation is particularly important for advisors during year-in-review client meetings where they evaluate progress and assess portfolio performance. In these meetings, it is essential that the advisor use appropriate benchmarks to ensure investors come away with an objective understanding of their investment performance. Comparing a conservative, risk-averse portfolio to a high-risk index, for instance, is an apples-to-oranges comparison that will leave the investor with an inaccurate perception of performance.  Another suggestion is to frame investment performance in context of the return required to meet your client’s goals over the long term. This reinforces a goals-based engagement and helps to center the client on their financial plan.

 

Investors remember the highs and lows

Another important consideration for advisors to keep in mind is that investors often concentrate on their portfolio’s high and low points when assessing its overall performance.  This connection is often driven by the acute emotional connection that investors experience during significant volatility. Research shows that they will remember the period when their investments performed exceptionally well, as well as when they dipped significantly, but that they rarely take into account the actual average performance. Similarly, many investors are affected by “recency bias,” or an inclination to remember what happened most recently without considering overall performance. This mentality can lead investors to exit the market at the first sign of trouble or to invest in an overvalued asset.

To avoid such short-term thinking, advisors need to consistently remind clients of their long-term goals, and provide proper benchmarks and comparisons that contextualize the limited period of time to which investors are reacting.

Employing the fundamentals of behavioral finance is just one component of an advisor’s toolbox. Beyond continually framing conversations and providing appropriate context, advisors can take advantage of several tangible resources to help manage their clients’ perceptions. At the end of the day, it is critical for advisors to understand their clients’ biases and perceptions, so that they can better direct them and make sure they remain on a path for long-term success. 

 

Matt Matrisian is Senior Vice President, Practice Management & Strategic Initiatives at AssetMark, Inc. @AssetMark.

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