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Tackling common behavioral biases in investing
Everyone has behavioral biases, so it’s no surprise that they can affect both advisors and investors.
Tackling common behavioral biases in investing
We recently surveyed 169 financial advisors in Canada about their personal biases and those they observe with clients.1 The three most common biases that we found in our inaugural Behavioral Coaching Survey were loss aversion, recency bias, and familiarity.
Loss aversion
That good feeling you get when you find $20 should, one would think, be equally strong as the bad feeling you get when you lose $20. But with loss aversion, the bad feeling is much stronger. Loss aversion can make people wary of investment risk, and word choice can trigger the aversion. For example, an investor with loss aversion may be willing to invest in something that has a 75% chance of going up. But tell that same investor that there’s a 25% of the investment going down, and the investor is more likely to shy away—even though the odds are the same.
In our advisor survey:
34%
Recognized this bias in themselves
62%
Reported this as the most common bias they see in clients
Loss aversion can affect asset allocation decisions. Advisors with loss aversion may limit growth opportunities for themselves and their clients by recommending investments that are more conservative than their clients’ risk profiles.
Recency bias
Ever hear about a shark attack shortly before a beach vacation? If the news made you feel wary about swimming in the ocean—despite knowing that shark attacks are quite rare—you’ve experienced recency bias. Simply put, recency bias is the tendency to expect recent events to recur more often than the facts suggest. For example, an investor with recency bias may expect a stock or market sector that’s on an upswing to outperform projections even though the projections are based on solid financial analysis.
In our advisor survey:
21%
Viewed this as one of their most common biases
50%
Indicated that this is the second most common bias they see in clients
Advisors and clients with recency bias are prone to let market news affect their investment decisions. Instead of sticking with a goals-based plan, they might select misguided investments or avoid investments that align with long-term goals.
Familiarity bias
Imagine that it’s time to buy a new car. Your old car has served you well. Will you research all your options and make a data-driven decision about your next purchase? Or find a good deal on a car made by the same manufacturer as your old one? If you skip the research and go with the current car-maker, your loyalty may be based in familiarity bias. Familiarity bias is that mental shortcut we sometimes take when making a choice. It leads us to avoid change, so we can stay in our comfort zone.
In our advisor survey:
62%
Reported familiarity bias within themselves
25%
Cited this as a common bias among their clients
Advisors and clients with familiarity bias have a tendency to invest assets that are familiar to them. This bias can result in under-diversified portfolios that limit clients from achieving their goals. A couple of common ways that familiarity bias influences investing include overweighting in domestic assets and investing too heavily in one’s own company stock.
What can you do about behavioral biases?
We like to think that every investing decision we make is based on facts and figures. But the reality is that it can be tough to take the emotion out of investing. This becomes especially difficult during market volatility—when emotions naturally run high.
“Rather than avoid this emotional terrain, advisors can create space for discussions about the existence of biases and their potential impact on clients’ financial health,” according to Anne Hoare, Head of Asset Management Solutions for SEI Canada. “Talking about these areas can put the advisor in a position to coach clients away from acting on biases and toward better outcomes.”
Goals-based investing is another way to overcome these biases. We believe a best practice is to build a separate portfolio for each client goal factoring in comfort with risk and time horizon— yet only 33% of advisors surveyed take this approach. Additionally, 41% of advisors surveyed reported that they haven’t created financial plans for more than half of their clients.
A goals-based approach offers many advisor benefits, including:
- Helping investors reach their goals
- Developing deeper relationships with their clients
- Increasing client retention
1 SEI’s Behavioural Coaching Survey, conducted in May 2023, incorporated 169 responses from advisors in Canada about their personal biases and those they observe with clients.