The Brain on Bias: Guiding Clients in Financial Decision-Making

Posted by Angela Sarver

October 16, 2019 at 1:30 PM

financial decision-makingAs advisors often experience, introducing change to clients can be a struggle, especially when money—an emotionally charged topic—is involved. Financial decision-making is not always, or even typically, rational and reasonable. Although most of us think we’re capable of making rational choices, only part of the mind has the capability to analyze a problem and come up with a rational solution, and this process can be slow and inefficient.

In contrast, the intuitive part of the mind works speedily—even automatically—and is responsible for most of what we say and do. But sometimes, the automatic decisions we make aren’t the right ones, due to emotional and cognitive biases. These biases affect our preferences and how we process information to reach decisions. They can prevent us from achieving goals we’ve created rationally, particularly those related to finances and investing.

How do biases work? There are far too many types to cover here, but I’ll explore those that advisors see most often, as well as strategies for addressing them.

Want to help clients with financial decision-making by getting to the heart of what motivates them? Download our free guide to get started.

Overcoming 5 Types of Client Bias

1) Loss aversion. We feel the pain of a loss much more than we feel the pleasure of a gain. This emotion is so strong that if a client loses $10, she would need to find more than $20 to make up for the initial loss. That’s why clients react so emotionally when the market declines.

To address this bias, follow these steps:

  • Acknowledge your client’s emotions. Emphasize that you understand why a loss, no matter how big or small, can lead to worry and panic selling. Providing empathy helps clients work through emotions and take a more reasonable approach to the current situation.
  • Ask why your client established financial goals in the first place. Remind him or her that you both expected dips in the market along the way to meeting them.
  • Demonstrate how you’re working to protect the client’s investments by focusing on the long-term strategies that will drive success.

2) Anchoring bias. When clients become fixated on a specific number, it’s typically due to anchoring bias. For example, say that a client receives a stamp collection appraised for $750 as part of an inherited estate. When trying to sell the collection, he refuses an offer of $500 because the amount of $750 is fixed in his mind. It has become an “anchor,” or judgment baseline, that influences the client’s ability to think rationally.

Your challenge is to help clients understand and focus on their goal, rather than on the asset itself. Ask clients what their decision is based on. In the example above, if the client acknowledges the original appraisal amount as the focus, you now have the knowledge needed to reframe the conversation. You might be able to present historical information or facts that counteract the anchoring bias. In general, by helping clients understand how their focus on the anchor affects their decision, you can empower them to rethink their position.

3) Confirmation bias. Seeking out information that matches what we already know is a natural tendency for us all. In financial decision-making, we prefer to consider information that confirms our existing beliefs, while ignoring other facts and opinions. This bias is especially well known as an influence in investment decisions.  

To counteract confirmation bias, try to get clients to see that they’re relying on a single point of view. To reframe the discussion, tell clients that you were curious about the information they shared, so you did some research on your own and found reasons for concern. By taking this step, you’ll acknowledge that you’re listening and taking their beliefs seriously. Emphasize that you’re vested in their success and want to help ensure that they get the best possible outcomes.

4) Recency bias. If there’s one statement we’ve all read (or said) countless times, it’s that past performance is not indicative of future performance. Rationally, clients know this. But emotionally, they need to hear it over and over because of recency bias. This type of bias means that people remember recent events more easily than those in the past, which can cause them to react irrationally. For example, when gas prices decline, sales of SUVs tend to increase because people expect gas prices to remain low.

To help clients understand the influence of recency bias, remind them to focus on their long-term goals. As appropriate, refer to your notes regarding your planning discussions. It’s also a good strategy to present clients with historical information demonstrating that no pattern continues forever.

5) Herding bias. Not too long ago, the financial news was all about how gold and cryptocurrency were the next hot things. If your clients wanted in, they were likely influenced by herding bias, which is the tendency to mimic the actions of a larger group, whether those actions are rational or not. Herding bias occurs because we have a strong need for social acceptance and feel pressure to conform. We also believe that the more people who buy into a decision, the less likely it is that the decision is incorrect.

Clients need to understand that the herd can’t be relied on to provide the right information, so help them do their homework. Emphasize that investors should give credit to facts and analysis rather than group behavior. Conduct your own due diligence so you can fully understand your clients’ objectives.

Asking the Right Questions

Asking the right questions—and listening carefully to the answers—can help you understand what biases are in play and what circumstances are driving your clients’ feelings. Here’s a list of effective questions I’ve collected from advisors across the industry that will help you get the whole story.

OvercomeBias_EffectiveQuestions

Document your discussions. Often, your clients may act emotionally and let biases sway their decisions, without being aware that it’s happening. To guard against misunderstandings later, create an accountability mechanism for documenting your discussions and review meetings. Be specific about details and how your clients’ financial plan might change based on future scenarios. You could also provide clients with a summary of the biases they may experience when making decisions.

Taking a Customized Approach

These recommendations won’t guarantee success, but they can help you build trust and deepen your client relationships. And I hope they’ll help you create a customized approach that addresses your clients’ emotional and cognitive biases. The result may be better outcomes for your clients and increased value for your practice.

Have you witnessed these types of bias when working with investors? What is your approach to helping clients avoid making emotionally charged decisions? Please share your thoughts and experiences below!

Behavior Modification

Topics: Behavioral Finance

   
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