Seven psychological biases often influence your investment decisions
Why financial advisors often describe their role as that of a psychologist rather than an investment manager.Author: Kenneth Corbin, Babylon Family Research
"A significant portion of respondents admitted that various psychological biases influenced their thinking about financial decisions."
Financial advisors often describe their role as more akin to that of a psychologist than an investment manager, and a new research report from industry research firm Cerulli Associates helps explain why.
Cerulli surveyed investors with assets over $250,000 and found that a significant portion of respondents admitted that a variety of psychological biases influenced their thinking about financial decisions.
These psychological biases include availability bias, confirmation bias, recency bias, overconfidence, loss aversion, herd behavior, and anchoring effect, which refers to when an investor clings to a specific data point and does not change their viewpoint even when new contradictory information emerges.
For Cerulli, this necessitates that financial advisors pay more attention to behavioral finance when dealing with clients, as clients are often bombarded with information from social media influencers, television experts, and countless other sources.
Cerulli analyst John McKenna stated, "For herd behavior and anchoring effect, a reliable third party with a comprehensive understanding of the financial markets can help clients identify the reasons behind this specific anchor point, thereby finding long-term solutions for their investment needs."
Cerulli found that the following seven biases are affecting wealthy investors' financial decision-making:
Availability Bias: This is the most common financial bias and perhaps the most intuitive. Cerulli defines availability bias as making decisions based entirely on "information that is readily available," rather than seeking out potentially conflicting viewpoints. Among the surveyed wealthy investors, 88% believe they exhibit some degree of availability bias.
Confirmation Bias: People like to think they are right. Cerulli points out that confirmation bias explains why people are drawn to media that aligns with their views, and investors tend to seek information that reinforces their existing financial strategy beliefs. 78% of surveyed investors reported having confirmation bias.
Recency Bias: Recency bias refers to the significant impact that recent news or experiences have on people's decision-making. It is one of the driving forces in the advertising world, where marketers do everything possible to build awareness around a product or brand. It is also an important factor in finance, with 67% of respondents in the Cerulli survey indicating they are influenced by recency bias.
Overconfidence: Almost everyone has likely encountered someone who fits this description. Many people believe they know more than they actually do, which can lead to very poor investment outcomes and poses a significant challenge for financial advisors trying to persuade stubborn clients not to make bad decisions. Among the surveyed wealthy investors, 59% believe they have a tendency toward overconfidence.
Loss Aversion: When helping to build portfolios, all financial advisors must consider their clients' risk tolerance, but if clients are too cautious, it can be a challenge. While overconfident clients may tend to take on more risk rather than being cautious, those at the other end of the spectrum may miss out on high yields or returns due to their loss aversion bias, with 67% of respondents reporting this tendency.
Herding: Recall the cryptocurrency frenzy of February 2022, when star-studded Super Bowl ads challenged investors to be bold and seize the opportunity to invest in cryptocurrency. While the cryptocurrency industry may be showing some signs of maturity, it is undeniable that there remains a significant amount of speculation in the market, with many investors buying into cryptocurrencies without truly understanding what they are doing, simply because they are "following the crowd or the latest investment trend." According to Cerulli's definition of herd behavior, 48% of respondents acknowledged the presence of herd behavior.
Anchoring Effect: Cerulli describes anchoring as "a natural complement to confirmation bias, as many people subconsciously use mental shortcuts to acquire and process information as quickly as possible." For investors, this may mean remembering a specific data point, such as a stock's IPO price or its 52-week high, and using that number as a reference point for future investment decisions. 46% of respondents indicated that they believe they are influenced by the anchoring effect to some extent.
