If your clients are clamoring for stocks they heard about on Reddit, making investing decisions based on what happened to them yesterday or refusing to buy overseas securities, they may be among the many investors who are falling for classic behavioral biases in the markets.
Advisors are getting better at using behavioral finance to help their clients hack their own brains and understand the error of their ways, to the benefit of their portfolio returns and financial planning. That’s the conclusion of a new study on behavioral finance that Schwab Asset Management, Cerulli Associates and the Investments & Wealth Institute released on Oct. 4.
The problem: clients, like everyone else, tend to use mental heuristics — shortcuts — when making decisions. It’s a hardwired human trait, one that allows us to save precious brain power by not re-litigating every decision every time we’re called upon to make one. But the issue with relying on your brain’s well-worn pathways is that you might misinterpret data and make your decision in an illogical way.
Over the past year, the pandemic and its attendant market volatility and economic uncertainty have forced clients to make many decisions about their investments. Predictably, in times of stress, the incidence of bias creeps up.
The most frequent bias advisors noticed in their clients’ behavior was recency bias, the tendency for something you’ve read or experienced recently to influence you. In 2021, 58% of clients exhibited recency bias, advisors said, compared to 35% in 2020, the study found.
“Clients overweight the importance of recent events, looking to get into the hottest tech stocks or the hottest meme stocks,” said Asher Cheses, associate director of wealth management consulting at Cerulli. “Acting as that behavioral coach for clients is a huge value add” for advisors.
Other biases advisors spotted included confirmation bias, or looking for information that backs up what you already believe (50% in 2021 vs. 24% in 2020); framing, or taking cues from the way the data is presented (44% in 2021 vs. 26% in 2020); and familiarity bias, the desire to keep money at home by investing in U.S.-based companies (43% in 2021 vs. 27% in 2020). Perhaps not surprisingly, clients also fell victim to loss aversion, the unwillingness to take on logical risks (43% in 2021 vs. 30% in 2020).
To fight these client biases, advisors found several behavioral finance techniques more helpful this year than last. Topping this list was taking a long-term approach, which 76% of advisors used successfully with clients.
“Sometimes the best thing you can do is shifting the conversation away from short-term results,” Cheses said.
Advisors also turned to goals-based planning (75%), systematic processes (66%), telling investors not to panic (52%) and diversifying client portfolios (48%).
“Our advisors are seeing these patterns over and over, and they’re being a little more proactive in helping clients understand this information,” said Devin Ekberg, chief learning officer and managing director of professional development at IWI.
As one example, social media is becoming an increasing part of the client conversation, with more than half of clients frequently asking their advisors about investments they learned about online, and 60% of advisors reporting their clients hold cryptocurrencies, Cheses said.
“Advisors did a good job of preventing their clients from investing in these speculative assets,” he said.
For advisors who used behavioral finance techniques, the top benefit of doing so was an increase in client retention and trust. Advisors also said they were able to keep clients invested when markets were volatile, reduce “emotional decision-making,” manage client expectations about their investments, and help clients make decisions based on their own priorities.
“As we’re trying to help our clients achieve their long-term goals, it’s very critical for advisors and providers to understand how information gets processed,” said Omar Aguilar, chief investment officer at Schwab Asset Management.
The survey, the group’s third annual study on this topic, was conducted in May and June, with the participation of 300 advisors who are members of IWI and range from wirehouse and IBD advisors to RIAs.
Sweaty palms and fidgeting
Why are advisors recognizing more biases in their clients now? It might be because the pandemic has sharpened the public’s focus on mental health and emotional behavior, making it more likely that advisors would see the signs, said Sonya Lutter, director of institutional research and education at Herbers & Company’s Academy.
“Advisors are extremely receptive to behavioral finance research to help clients make the most of their money,” said Michael Liersch, head of Advice and Planning for Wells Fargo Wealth and Investment Management.
First, advisors work through a goals-based plan with clients, asking them what they want to achieve with their money and when, and understanding how those priorities rank in importance for the client. Then they flip the behavioral-finance switch: “Advisors then help clients make the shift from what might be feelings-based decision making to what from an analytical perspective is an approach that probabilistically leads to better outcomes,” Liersch said.
Advisors need to listen to their clients and have empathy for their feelings — “feelings matter, and they need to be acknowledged, understood and accounted for when it comes to money” — but the objective is to help the client answer one question, Liersch said: “What can I be doing to make incrementally better money decisions?”
As clients try to dig their lives and finances out from under COVID’s debris, they may fall victim to different biases, said psychologist Sarah Stanley Fallaw, founder and president of automated behavioral-finance software company DataPoints. Extroverted clients may want to rush into fashionable investments like meme stocks so they’ll have a trendy experience to share with friends, while anxiety-prone investors may try to assert control over their lives by making “drastic moves,” she said.
When that happens, advisors should step in. To help clients avoid investing irrationally, it’s first important to make sure advisors aren’t overworked or burned out, which could make it tough to spot “physical signs of incongruence in values and behaviors with clients — which means paying attention to heightened physiological stress that cannot be easily masked,” Lutter said.
She recommends looking for cold hands, sweating, fidgeting or inability to make eye contact, all signs that a client may be having trouble focusing. If a client insists on making an investment decision while under this sort of mental duress, the advisor can suggest checking back in the following week to make sure the client still wants to take action, or asking if the advisor can call the client in the morning after checking through some procedures.
“Basically, the advisor is intentionally delaying a decision to create the space for the client’s brain to reset, which is why it’s so critically important for advisors not to be overworked, rushed and/or working over capacity with clients,” Lutter said.
