Wall Street and modern portfolio theory, which lays the groundwork for asset allocation and much of today’s investment management, assume the following: Investors are rational. Therefore, logical facts and analysis will guide them to success in investing.
But if that’s true, why do investors keep sabotaging their goals through irrational behavior?
“It’s irrational to anticipate rationality,” Jay Mooreland, a behavioral coach for financial planners, said in a telephone interview. “It’s not in our DNA.”
Fortunately, once investors recognize the emotions and biases that drive their behavior, they can work to counteract them. CPAs can draw insights from the field of behavioral finance to help them do so.
Mooreland, who spoke Monday at the AICPA ENGAGE conference in Las Vegas, uses psychology to give advisers the tools and skills they need to help curb clients’ most dangerous behavioral biases and prevent them from making costly mistakes.
Behavioral finance “enhances the financial planner’s value and supports evolving, deepening relationships with clients,” he said. His approach, he said, “is to help others understand why we make those mistakes and learn correct perceptions, so we can improve our future decisions.”
Mooreland explained why humans are irrational, warned of the dangers of investor irrationality, and gave practical suggestions as to how CPA financial planners can counter clients’ irrational tendencies and help them change their investing behaviors for the better.
“Our business is being hurt by not addressing these behavioral biases,” he said.
Mooreland said that if advisers are not actively helping clients to counter their irrational or emotional gut responses to market events, they may feel safe as long as clients don’t realize that level of service is available elsewhere. But if lower-cost competitors begin to offer that kind of service, he predicts that most advisers will be playing catch-up, responding defensively rather than proactively.
Behavioral biases that can influence investing
Behavioral biases are based, in part, on the mental shortcuts everyone tends to take to simplify decision-making, along with other emotions that can trip people up. Some of the main biases that affect investing, according to Mooreland, are:
- Overconfidence. People often think they are smarter as investors than they actually are, which can lead to disastrous results.
- Anchoring, or using irrelevant information as a reference for evaluating other information. For example, because a stock had been at a certain price before falling, an investor might assume it will rebound to that price, even if a rational analysis would conclude otherwise.
- Herd behavior, or being so fearful of making a decision outside the norm that a person opts for an ill-considered or riskier conventional choice. A salient example is the herd mentality that typified the dot-com bubble of the late 1990s and how even rational individuals and portfolio managers were swept up in it. The challenge is to maintain an individual viewpoint at a time like that.
- Regret avoidance, or when people refuse to admit to themselves that they’ve made a poor decision so they can avoid the unpleasant feelings associated with that admission. Regret avoidance can come into play when investors refuse to take corrective action rather than admit they’ve made an investment mistake.
Any of these behavioral biases can potentially sabotage clients’ long-term objectives. So advisers shouldn’t ignore them, Mooreland said.
To help keep clients from making emotionally charged investing mistakes, Mooreland said, financial planners need to understand these behavioral biases, identify them, and work to counter each of them.
Here are some ways advisers can counteract their clients’ behavioral biases:
- Teach them to ignore financial media hyperbole. Sensational stories that encourage audiences to watch or click may be good for media outlets, but they don’t benefit investors and their decisions. Mooreland recommends that investors read articles, not just headlines, and do so critically, asking what long-term relevance, if any, the information they consume might have on their portfolio.
- Get clients to recognize and override their emotional gut reactions. Emotions can be powerful but dangerous drivers of decisions. The key is to understand and recognize that we are by nature emotional beings. “Once we recognize that we are influenced by emotion,” Mooreland said, “we can reduce the risk of emotional responses simply by delaying our decision until the emotion subsides and real logic returns.” In other words, sleep on things before acting, giving you more time to analyze information more thoughtfully.
For information on helping clients in emotional situations, attend this free webcast featuring Ted Sarenski, CPA/PFS, and Jean-Luc Bourdon, CPA/PFS, 1 to 2:15 p.m. ET, Aug. 16.
—Allan Kunigis is a Vermont-based freelance writer. To comment on this article, email senior editor Courtney Vien.