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Drawing incorrect conclusions, based on ill-conceived heuristics, can lead to bad decision making. This is cognitive bias. Researchers have identified an enormous range of cognitive biases that can apply to financial decisions. Effective wealth managers must know enough behavioral finance to identify various types of cognitive bias and determine how to navigate clients’ investment behavior accordingly.
Here are a few of the most common biases in behavioral finance:
1 - Loss aversion
Loss aversion doesn’t mean that people would prefer to avoid losses – because that would be completely rational. Instead, loss aversion refers to having a much greater desire to avoid any risk that could bring about a loss, rather than to acquire a similar gain. An identical outcome can cause more distress if it’s framed as a loss rather than as a missed opportunity for a gain. Reframing decisions around the gain is one way to combat loss aversion bias.
2- Sunk cost fallacy
The sunk cost fallacy happens when you invest more money in a losing project with the hope of recouping earlier investments. Coincidentally, the more you invest in something, the harder it becomes to abandon it. As an advisor, it’s important to work with clients and show them the bigger picture when they’re making poor investment decisions based on past expenditures. Sometimes it’s best to cut losses and move forward.
3- Familiarity bias
Familiarity bias leads investors to prefer stocks in companies that they buy products from, that they work for, or where they have a family connection. Because of familiarity bias, investors may perceive that an investment is less risky than it really is, simply because it’s familiar to them. Any concentrated investment in a single company can be risky, no matter how familiar you might be with it.
4- Status quo bias
Status quo bias is a preference for the current state of affairs. It’s the act of avoiding change due to the risk of loss compared to the status quo reference point. A person who inherits an investment portfolio and decides to make no changes – preserving the investments received, rather than fully incorporating the investments into their own portfolio, is an example of status quo bias. The sentimental attachment to the stock and the bias to keep things as they are can be problematic if doing so assumes undue investment risk that can jeopardize the client’s goals. A wealth manager can help their clients overcome the status quo bias by reframing the decision in light of the client’s broader objectives and investment portfolio.
Applied wealth management
Wealth managers who understand cognitive biases can use this knowledge to help better manage investor confidence and steer clients back on the right path. Using behavioral finance techniques and other applied wealth management strategies can be an incredible value-add for advisors in the personal wealth management space.
This article was adapted from the behavioral finance curriculum in the award-winning Wealth Management Certified Professional® (WMCP®) designation developed by The American College of Financial Services. Consider earning the WMCP® designation if you are a financial professional seeking to enter or transition your practice into the personal wealth management space. TheAmericanCollege.eduWMCP
Learn more at www.TheAmericanCollege.edu.