Author: Kenneth Corbin, Babylon Family Studies
“A large portion of respondents acknowledged that various psychological biases influence their thinking about financial decisions.”
Financial advisors often describe their role as more like a psychiatrist than an investment manager, and a new research report from industry research firm Cerulli Associates helps explain why.
Cerulli surveyed investors with assets of $250,000 or more and found that a large 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, herding, and anchoring, which is when an investor latches onto a specific data point and won’t change their opinion even if new, contradictory information emerges.
For Cerulli, that requires financial advisers to take behavioral finance more seriously when dealing with clients, who are constantly bombarded with information from social media influencers, TV gurus and countless other sources.
“For both herding and anchoring, a trusted third party with a comprehensive understanding of the financial markets can help clients find the reasons for this particular anchor and thus find long-term solutions for their investment needs,” said Cerulli analyst John McKenna.
Cerulli found that the following seven biases are affecting wealthy investors’ financial decisions:
Availability Bias: This is the most common financial bias and perhaps the most intuitive. Cerulli defines availability bias as making decisions based solely on “information that is readily available” rather than looking for potentially conflicting viewpoints. 88% of wealthy investors surveyed believe they have some degree of availability bias.
Confirmation bias: People like to think they are right. Cerulli notes that confirmation bias explains why people are attracted to media that agrees with their views, and investors also tend to seek out information that reinforces existing ideas about financial strategies. 78% of investors surveyed said they have confirmation bias.
Recency bias: Recency bias refers to the outsized influence that recent news or experiences have on people’s decisions. It’s one of the driving forces in the advertising world, where marketers do whatever they can to build awareness around a product or brand. It’s also a big factor in the financial industry, with 67% of respondents to a Cerulli survey saying they were affected by recency bias.
Overconfidence: Almost everyone has probably met someone who fits this description. Many people think they know more than they actually do, which can lead to very bad investing outcomes and creates significant challenges for financial advisors who try to talk stubborn clients out of making bad decisions. 59% of wealthy investors surveyed identified themselves as having a tendency to be overconfident.
Loss Aversion: All financial advisors must take into account their clients’ risk tolerance when helping build a portfolio, but this can be a challenge if the client is overly cautious. While overconfident clients may be inclined to take more risk than being cautious, those on the other end of the spectrum may miss out on high gains or returns because of their loss aversion bias, which 67% of respondents reported.
Herding: Think back to the cryptocurrency frenzy of February 2022, when a celebrity-studded Super Bowl ad challenged investors to be bold, take a chance, and invest in cryptocurrencies. While the cryptocurrency industry may be showing some signs of maturing, it is indisputable that there is still a lot of froth in the market, and many investors are buying into cryptocurrencies without really understanding what they are doing, and they are doing so simply because they are "following the crowd or the latest investment trend," according to Cerulli's definition of herding, which 48% of respondents agree with.
Anchoring: Cerulli describes anchoring as “the natural complement to confirmation bias, given how many people subconsciously use mental shortcuts to take in and process information as quickly as possible.” For an investor, this might mean memorizing a specific data point, like a stock’s IPO listing price or 52-week high, and using that number as a reference point for future investment decisions. 46% of respondents said they believe they are influenced by the anchoring effect to some degree.