Journal of Financial Planning: August 2021
We like to think that we are all rational, but that isn’t always the case. How many times have you recommended a course of action to a client, only to see them turn around and do almost the exact opposite? It can be disheartening, but you shouldn’t take it personally. There are a lot of biases that will lead an investor astray. Knowing some of the biggest culprits and how to work around them will ensure that your client’s train to financial security does not get derailed.
Some clients trust themselves to identify stellar stocks too much. A lot of investors who are found to be overconfident tend to trade too frequently, often at the cost of future gains, according to PIMCO. Many studies have shown that clients who made frequent trades made less money, as cited in several journals including the Journal of Finance. Help your clients identify a suitable portfolio and stick with it. Break it to them easily that they are likely not cleverer than the global market of computer-backed institutional investors.
People hate being wrong. That extends to buying stocks. Sherman Wealth Management says that people will sometimes hold onto a stock that is going down in value because they don’t want to face the truth that they have lost money. The sunk cost fallacy comes into play, and people don’t want to let go because they’ve already invested money into it. Creating a comprehensive set of rules for your clients to follow can help remove the emotional element of investing.
Limited Attention Span
Everyone has a limit to the amount of attention they can give to any one topic. Since your clients have elected to hire a professional, it likely means they are occupied with other aspects of their lives. Regardless, they will have heard of some successful companies. They may think that investing in Apple, Amazon, etc. is where the money is. The truth is there are thousands of stock options to pick from, and your clients likely haven’t even heard of 90 percent of them. Don’t let the news and pop culture guide your clients. The immediacy can cloud judgment and cause them to miss options that would truly round out their portfolio.
Humans like to see patterns and extrapolate from them. If one financial product has been performing well recently, it is easy to assume that the trend will continue. Remember the GameStop fiasco? That was underground for a while, and you would have benefitted had you gotten in early. But by the time it really broke out in the news, it was already starting to plateau, and you likely would have gotten burned if you bought stocks then. If you are hearing of a trend, it is quite likely that others in the market have already latched onto it, removing any future gains.
There are other aspects of these biases to be cautious about, and there are additional cognitive biases that can influence an investor’s behavior. But there are many ways to address these issues when they pop up with your clients, and we trust this issue of the Journal of Financial Planning will provide you with some insight and solutions to the irrational decisions that clients can make. Sometimes you need to remind your clients that you are the professional. Do not let their biases take control.