Behavioral finance tricks to combat clients’ investing bias

CHICAGO — There are two main causes of investor paranoia: High stakes and confusing events.

Recessions, bubbles and bear markets often happen for reasons that clients can’t quite understand and certainly can’t control, said Morgan Housel of the Collaborative Fund, at the Morningstar Investment Conference. Fortunately, these kinds of events can teach advisors about the general investing public they are looking to serve. That’s because they offer case studies in how individuals react — and overreact.

“Not in any other industry in the world do you have otherwise smart people become gullible, paranoid and lose the ability to look at risk in a rational way,” Housel said.

Good investing is not about what you know but how you behave, said Housel. Likewise, successful investing is not about making great decisions but about consistently not making mistakes.

But teaching good investing behavior to clients can be harder than it seems. Because behavior cannot be easily analyzed, it’s challenging to get clients to react rationally to detrimental investment scenarios.

“Behavior is hard to teach even to extremely smart people,” Housel said.

For example, if a client grew up during the Great Depression, they are half as likely to invest in stocks as a client who was raised in the 1960s. If a client grew up in the ‘70s, they will be one-third as likely to invest in bonds as someone who grew up in the ‘50s. And clients who grew up in the ‘80s are twice as likely to buy stocks as someone that grew up in the previous decade. (In the 1970s, the average inflation rate was 7.9%, almost six percentage points higher than in the 2000s.)

These findings suggest that individual investors’ willingness to bear risk depends on personal history, Housel said. In other words, it’s important planners learn more about their clients’ backgrounds when helping them plan for volatility.

Note for human planners: digital investing platforms use behavioral finance to improve investor results. The leading independent robo advisor Betterment already incorporates behavioral finance elements into its client platform, said Dan Egan, Betterment's director of behavioral finance. For instance, the firm now employs visual cues to indicate whether a client is doing enough to reach their goals, or if they need to save more.

To help steer clients, advisors can remind them to talk to many other investors and seek out a variety of viewpoints. Friends, neighbors and online investing discussions are good ways to learn more, Housel said.

“Realize that people that make different decisions than you are not always crazy,” he said, and make sure clients don’t immediately disregard those with differing points of view. “Personal finance is more personal than finance,” said Housel.