We all have cognitive biases — ways in which our thinking can be flawed, skewed, or driven by emotion rather than logic. Our cognitive biases serve a purpose: They develop out of a need to sort through vast amounts of information in our daily life and make sense of it quickly.
However, cognitive biases can also negatively affect how clients handle money. They can keep clients from making rational decisions about how to manage their money and what to do when confronted with tough situations.
Clients may not be able to recognize their own cognitive biases. Therefore it's helpful for CPAs to learn to spot some of the most common cognitive biases and how they can affect clients' thinking. Here are a few cognitive biases financial planners are likely to encounter and ways to help clients move past them.
The house-money effect: This cognitive bias relates to our tendency to make riskier decisions when it's not our hard-earned money we're putting on the line. For example, if you win $1,000 at the roulette table, you might risk it more willingly than $1,000 from your paycheck. The house-money effect can affect how a client decides to invest.
Jean-Luc Bourdon, CPA/PFS, founder of Lucent Wealth Planning in Santa Barbara, Calif., sees this effect play out with clients often. "People with huge gains from investing in companies like Apple and Tesla aren't eager to diversify their money and put these gains into a less risky option," he said.
To help clients think about the risk differently, he puts the gains they've earned in another context. "I ask them to imagine that we sold the stock and now that money is sitting in their bank account. How much of it would they reinvest in the company?" Bourdon said. If their answer is that they wouldn't be willing to reinvest the entire sum, it opens a discussion about how much risk they want to continue taking. Having clients imagine that it is tangible cash that they can do something with helps them to pause and start considering the situation in a more rational way, he said.
Risk aversion: If you ask people if they'd rather get $1,000 right now or flip a coin for a chance of winning $5,000, many would go for the sure bet. That happens because our fear of losing is greater than our excitement for winning. And it's this risk aversion that can have a great effect on how we approach the risk that accompanies investing.
Lisa Featherngill, CPA/PFS, head of legacy and wealth planning at Abbot Downing in Winston-Salem, N.C., illustrates how this situation can be problematic. "Clients will say they'd rather put their money in CDs to keep it safe, rather than invest it," she observed. "They'd rather not lose any money, even if that means forgoing possible gains."
Demonstrating how risk aversion can affect a client's financial wellbeing may make them realize that playing it too safe isn't the ideal option. Featherngill suggests using modeling to show the impact their choices can have on their long-term wealth. For example, if a client says they want to stick with CDs, a CPA could "model the impact that decision would have on their net worth over the long run and the impact that would have on the rest of their life," she said.
Sunk-cost fallacy: The cognitive bias referred to as the "sunk-cost fallacy" occurs when someone has invested resources (time or money) into an endeavor and insists on continuing with it even if it's no longer going well. For example, a company may continue working on an expensive project that likely won't give them the outcome they're looking for, just because they've already spent so much on it. Or a client might refuse to sell an investment because they don't want to sell it at a loss.
Giving clients additional data can help them move past the sunk-cost fallacy, Featherngill said. "I'll have clients say, 'I can't sell my stock at a loss! I paid $5,000 for it, and if I sell it now it's only worth $3,000,'" she recalled. "That's when my investment partners share information about what the outlook for the stock is."
She also recommended showing clients the advantages of what might feel like a painful decision. If they're reluctant to sell an investment at a loss, for instance, she will "try to put it in a more positive light by showing them they can take a capital loss against other gains."
Familiarity bias: We tend to favor things that are known to us: a local sports team, a neighborhood coffee shop, or a company we've heard a lot about lately.
This tendency also holds true for investments. "When people are investing, they are more likely to invest in companies that have made the news, simply because they have heard the name. We relax a bit more in the presence of familiarity. It makes us feel safer," said Moira Somers, Ph.D., a psychologist based in Winnipeg, Manitoba, and author of Advice That Sticks: How to Give Financial Advice That People Will Follow.
The familiarity bias might mean that someone will want to continue investing in companies they've invested in for a long time or hold onto investments they've inherited. It might also mean they feel more comfortable investing in companies they know, such as their employer.
If this bias isn't serving clients' best interests, how can advisers help?
Somers suggests finding a way to help clients think through their choices. "Since one of the biggest contributors to bias is the need to simplify things to make decisions, it's important to intentionally help clients slow down and broaden their decision-making framework," she said. She suggests asking them what they hope to gain from the investment and whether they are open to considering alternatives.
But Somers also cautions advisers to not jump to conclusions when they think they've identified a client bias and irrational thinking. "Clients can make decisions based on more than just the return. They may not want to invest in a company that offers a high rate of return because it conflicts with their values," she noted. "Sometimes what looks like bias to one person can be a values-based decision from a different perspective."
— Erica Gellerman is a freelance writer based in Hawaii. To comment on this article or to suggest an idea for another article, contact Courtney Vien, a JofA senior editor, at Courtney.Vien@aicpa-cima.com.