A N A D V I S O R’S G U IDE T O B E HAV IO R A L FINA NCE

explores investor psychology from an advisor’s perspective. The

guide examines the causes of investor behavior and the biases
that undermine sound investment decisions, offering concrete
suggestions for addressing these biases. The guide also positions
investor psychology as a critical tool for enhancing client relation-
ships and building a business.

R A L F I N A N C E
B E H A V I O
R A L F I N A N C E e average, and
or low toward their long-timmistakes as
B E H A V I O TAKING A NARR
OW VIEW
lves in situ- so may not make the same nced investors

Biases
Investorsave
Biases tend to exert themse
ations that are
charged—and investi
uncerta in or emotio
ng is both. The
financial markets
nally new investors. But experie bias.
aren’t immun e to probab ility
Try asking a cross-section running
of clients if
time but
Short-cuts can ups and downs of the
few things evoke
they’re more concerned
about
ent or being
the are unpredictable, and short of money in retirem
they can send you down stronger feelings than
one’s own money.
vulnera ble wiped out in a market crash.
e, it’s certainly
Investors are especially tions of While either is possibl
wrong road. percep
to biased, or distorted, it affects much more probable,
based on historical
way e, that inflation is
of sensory data probability and the and anecdotal evidenc al security.
Think about the torrent investment risk. the greater threat to financi
brain and nervous s at a basket- tends to grip
that floods the human Think about what happen sinks three Yet the possibility of a crash inflation
of every hour.
system every moment a city street ball game when the star
player
investor emotions in a
way that
Even when you walk down field goals, one after the
other, as the
risk does not.
processing
on your lunch hour, you’re ation from clock runs out.
inform
enormous amounts of g to the The crowd, THE STING
your environment—reactinsmells, sounds, caught up in OF BIAS
weather, evaluat ing sights,
of passers-by, the energy of Do you have clients
and the body language the moment, who lost money
crosswalks. You’re
negotiating traffic at is absolutely when the technol-
ng your surroundings
also constantly surveyi as speeding convinced ogy bubble burst in
for potential threats—such the salad or he’s on a roll 2000 and who still
s, like
vehicles—and reward for lunch. shot—especially
and can’t miss the next refuse to invest in
sandwich you plan to
buy You could never called the snake-
to perform even if it will win the game. s tech stocks? This bias— clients unable
It would be impossible most basic
the player’
persuade them that, despite is no more bite effect—makes your
make the rewards of the
the simplest tasks or obvious skill, hitting the
fourth
to see that the risks and
to work through all the first different now than
judgments if you had and deliberately. or less probable than
his hitting
sector are completely
of these cues consciously reacts very ing of the century.
human mind one was. iasm for they were at the beginn your bite-shy
why the kind of enthus ting
That’s
ation it takes It’s the same And it may be preven
selectively to the inform and rules of probable that age of strong
what is possible but not clients from taking advant
ts
in, by employing shortcu sions, evaluate drives some of opportu nities.
the investment growth spectrum is the
thumb to arrive at conclu s, and assess On the other end of the
potential risks and reward choices certain money effect,
bias known as the house
clients make from the world of
expression borrowed
when they mis- an
gambling.
take a recurring casino
pattern as a Like inexperienced
lar outcomes. . Why do they gamblers, investors
the likelihood of particu economists predictor of future results performing may be inclined
ral
Psychologists and behaviosimplification. gravitate to last year’s
best
to take excessive
call this process heuris
tic
year’s hot commodity if it’s
fund or this
magic to last? risks shortly after
not that they expect the experiencing an e your clients
ORIGINS OF BIAS investment windfall. Becaus s as their
ts can make people
The use of such shortcu MISDIRECTED WORR understand
Y
haven’t assimilated the
earning
al ways, because greater and often
act in apparently irration feelings, and rs
More experienced investo ance or com- own, they tend to take
their past experiences,
their perform far off strategy.
the tendency of fund ill-conceived risks, veering in steep

• Pillars of • Risk Avoidance

e sense of what is pleasurable from a curren t high ly result
their intuitiv decisions. The modity prices to move These actions typical
influen ce their identified
or painful losses. Researchers have
result of all this is bias. among a wide
You may find the IVE SAMPLE the house money effect
Everyone has biases. UNREPRESENTAT individuals to
and the World Cup ces of variety of investors, from
After the back-to-back experien

Investment
World Series exciting and accumul ating ional traders .
. You may put New winning big in Las Vegas
profess money biases
tedious, or the reverse technology The snake-bite and house bias known
destination list or impressive gains in the two on a roll.
York at the top of your was le another important
You may love or stocks in his portfolio , Tim resemb
, which results
relegate it to dead last. would hold, he as representativeness
red but not white wine, Convinced his lucky streak investment as
hate jazz, drink in investors labeling an

Success
rforming
told his advisor to sell his underpe

• Neuroeconomics
and despise beets. on its recent perfor-
seemingly gy stocks. good or bad based
Most people think of these , but they assets and buy more technolo by reducing helps to explain
risk mance. It’s a bias that
irrational judgments as
benign Tim not only increased his ably break the
ce on feelings, error of why investors predict
can exert enormous influenwhen these diversification. He made the on a too-small investm ent rule. They buy stocks
calculating probability based success, he
golden
thoughts, and actions
. And expecting those
applied to personal whose prices have risen, they ignore

NTROLLE
cognitive shortcuts are sample size. Heady from his all technology And
increases to continue.
finances, they can lead
investors away ignored the realities that not and no sector hen their
rm thinking to highly stocks—or sell at a loss—w ental values.
companies perform the same
from rational, long-te
O D
fundam
cial reaction that falls forever. prices are below their
charged and prejudi is hot

• Mental
on precon ceived notions and old 13
back
problem solving.

C
patterns of thinking and

Accounting
12

Lightbulb Press, Inc. AU

www.lightbulbpress.com T O M AT I C
[email protected] Phone: 212-485-8800
• Framing
• Biases

VIRGINIA B. MORRIS

205 East 42nd Street, 20th Floor

New York, NY 10017
(800) 99-HERON
www.heronwealth.com
 C O N T E N T S
2 Perspectives on Investing 14 Types of Biases

4 Pillars of Investment Success 16 Mental Accounting

6 Behavioral Finance 18 Action Plans

8 A Glimpse Inside the Brain 20 Redefining Advice

10 Neuroeconomics 22 Creating a Checklist

12 Investor Biases 24 Glossary

 B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E

Perspectives on Investing MEET BEHAVIORAL FINANCE

Advocates of behavioral finance—some-
times known as behavioral economics or
It’s time for a new look at how investor psychology—have spent nearly 50
years exploring the investment decisions
investment decisions are made. people make and why they make them.
These researchers and practitioners have
As an investment advisor committed to observed, for example, that people often:
helping your clients meet their financial
goals, how do you feel when they make • Make decisions based on fear of making
a mistake rather than on a rational
investment decisions that aren’t in their
assessment of probable risk and return
own best interests?
Frustrated? Angry? Convinced that • Base decisions on recent short-term
you’ve wasted your time? Afraid you’ve investment performance
failed because you weren’t able to
convince them your advice was sound? • Overload on stock in companies they
work for or are familiar with
Despite all your rationalizations
that clients are free to make their own • Resist selling faltering investments,
decisions, chances are their financial even when they would provide useful
successes and disappointments are MODERN PORTFOLIO THEORY BEHAVIORAL FINANCE capital losses
something personal to you, something
emotional. If you feel as strongly as you do Investors can maximize their return for Investor losses have more than twice the
• View retirement, education, or other
goal-focused accounts as stand-alones
when it’s not your money, you can imagine any level of risk they’re willing to take by impact on future investment decisions than rather than as components of an
how important not making mistakes is to using asset allocation and diversification to investor gains. overall portfolio
the person on the other side of the table. select an optimal combination of securities.
That’s precisely the reason it’s the Most of this isn’t news to you, and
right time to augment your skill at secu- A security’s price accurately reflects all Investors tend to categorize securities you could probably add several items to
rity selection and portfolio allocation the information that’s available about as either good or bad. When a security a list of illogical investment decisions.
with new expertise: understanding and that investment. Any incorrect prices will is seen as good, it has outperformed the What you may not know is why investors
managing investor behavior. immediately return to their real value market, and when it is seen as bad it has act in the ways they do. That’s why be-
through arbitrage. underperformed. There is no sustained coming familiar with psychological and
LOGICAL EXPECTATIONS link between these perceptions and the physiological perspectives that behavioral
You can expand your professional focus security’s fundamentals. finance provides can help. You can be more
to include how and why investors may effective at recognizing and dealing with
react as they do to the advice you provide. An investor’s investment plan should be People pigeonhole their money into the conflicting emotions that underlie many
This represents a break with what you and integrated so that different needs like separate accounts and treat each category poor investment decisions.
most of your colleagues have traditionally retirement, education, and current income as self-contained, treating risk and return If you can help your clients recognize the
considered your jobs as financial advisors. are seen as one risk/return proposition. in wildly different ways depending on how reasons they make some of the choices they
But, as you’ll discover, adding this new that category has performed. do, they may make better ones. That’s one
perspective can help you more effectively reason why behaviorism, according to re-
tailor the advice you provide because Taxes play a key role in investment returns Investors avoid selling losing stocks and cent Nobel laureate Daniel McFadden, “is a
you’ve already anticipated the reactions over time, so should always be a consider- are quick to sell good performing ones, fundamental re-examination of the field. It’s
it might provoke. ation in making buy and sell decisions. regardless of the tax consequences. where gravity is pulling economic science.”

A TALE OF TWO THEORIES

BEHAVIORAL 1973 1979 1980 1985 1988 2002
FINANCE Amos Tversky and Tversky and Kahneman Richard Thaler publishes Thaler publishes “Mental Accounting Meir Statman publishes Kahneman wins the
Daniel Kahneman publish “Prospect “Toward a Positive Theory and Consumer Choice,” which explores “Investor Psychology and Nobel Prize in Economics
describe the role of Theory,” which analyzes of Consumer Choice,” a the concept that people pigeonhole Market Inefficiencies,” for the work he did with
heuristics in decision- how investors make discussion of the impact their money into separate accounts and which explores the fear Tversky to develop
making, the first decisions in the face of of framing, or how analyzes the negative consequences. of regret that drives many behavioral finance.
exploration of certain loss. information is presented. investor decisions.
behavioral finance.

1930 1940 1950 1960 1970 1980 1990 2000 2010

MODERN 1934 1952 1962 1965 1990

PORTFOLIO Benjamin Graham’s Security Analysis Harry Markowitz William Sharpe articulates Eugene Fama publishes Harry Markowitz, Merton
provides a formula to identify the introduces the the capital asset pricing model “Random Walks in Miller, and William Sharpe
THEORY value of a security and determine concept of modern (CAPM), a formula for determin- Stock Market Prices,” win the Nobel Prize in
when to buy or sell. Sometimes called portfolio theory. ing the return investors demand exploring the thesis of Economics for their work in
the introduction to strategic investing. in return for taking risk. an efficient market. modern portfolio theory.
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 B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E

Pillars of Investment
successful urging moderation, you might
get them to try hedging. While there’s no SETTING THE RECORD
upside and significant downside to con- STRAIGHT

Success stantly monitoring traditional securities,

that’s not the case with options contracts.
To make money with these derivatives,
In 1986, Gary Brinson, Randolph Hood, and
Gilbert Beebower released a study entitled
“Determinants of Portfolio Performance.”
You may want to redesign the way you clients must be constantly engaged. While In the study, the economists compared the
there are costs involved, and potential performance of actively managed pension
present classic investment strategies. tax consequences, your real agenda is funds to indexed funds containing the same
deflecting attention from trading in allocation of stocks, bonds, and cash. They
As you learn more about why your clients make their core portfolios. found that asset allocation accounted for
some of the investment decisions they do, you’ll over 90% of the variance in the long-term
be more adept at detecting the warning signs. performance of the portfolios.
And because you sense what’s coming, you’ll Though the study addressed volatility
have time to point out potential—but RISK RETURN and not long-term returns, investors and
unforeseen—consequences or suggest their advisors have often mistakenly
an alternative course before they overemphasized the role of allocation in
hang up the phone or click the portfolio performance while ignoring other,
“submit trade” button. DIVERSIFICATION equally relevant factors.
RISK AND RETURN
You face a particular challenge IT’S ALL IN THE TIMING
with clients who are eager to If you were asked to identify the most
BO N DS avoid risk, as many of them difficult aspect of successful investing,
are, even at the expense of you and your colleagues would probably
CASH achieving their goals. Although agree that it’s knowing when—rather
they may acknowledge when than what—to buy and sell.
you’re face-to-face that every In the best possible scenario, your
STOCKS investment poses some risk, clients follow your advice and adopt a
they may not be willing—or buy-and-hold strategy for their core port-
emotionally capable—of ignor- folios. But in a more typical situation,
ing declining prices or falling they want to get out of equities when the
PORTFOLIO BUILDING indexes long enough to ride SECURITY SELECTION stock market is down even though you’ve
The first pillar of investment success is helping out the current turbulence. The second pillar of investment explained market cycles as explicitly as
your clients construct strong, diversified portfolios At the opposite end of the success is selecting the right combi- you know how.
by allocating among distinct asset classes chosen spectrum are equally problem- nation of securities to diversify your Similarly, they’re predictably drawn
to fit their goals, timeframes, and risk tolerance. atic clients who are so eager clients’ portfolios. It’s not something to last year’s best performing market
Modern portfolio theory seems to suggest that to make a financial killing and most clients do successfully on their sector even though the more tactically
determining this allocation is a mathematical so confident of their own skill own, as you probably know all too well. sound approach is to look for next year’s
exercise, in which, by measuring expected return, that they ignore your warnings So it should come as no surprise that opportunity. Managing investor behavior
standard deviation, and correlation, you identify the that they’re overloaded on this is another area where investor to avoid such instinctive yet self-defeating
most appropriate asset classes in the most efficient too few investments or have behavior gets in the way of logic. reactions may rightly be called the third
percentages for each individual investor. too much committed to risky Is this a problem you can solve? pillar of investment success.
Most advisors know better, as the asset allocation endeavors. If fear drives the The answer is a qualified yes, though To help your clients think and act
that their clients gravitate toward is anything risk-averse group, then greed finding the solution for each of your differently, you need a fuller grasp of the
but rational. drives this one. clients may require a dialogue in psychological and neurological explana-
Consider the typical response when you present One proactive approach which they’re willing or able to explain tions for why they behave as they do.
the case for thinking about asset allocation in global is to rethink your customary why they’ve made the investment
terms. Unless you’ve been more persuasive than most portfolio construction. For choices they have. One opener is to
of your colleagues or have savvier clients, chances example, you might stress look together at the way they’ve AN AVERSION TO REGRET
are that few have even 10% of their equity portfolios safety at the expense of strong diversified their 401(k) portfolios, Ed’s financial advisor suggested he make
invested in companies headquartered outside the returns for the nervous inves- since it’s likely they made these a long-term investment in a mutual fund
United States. tors even though you recognize decisions on their own. that had recently lost value and been
That’s the case, despite the fact that the US stock it will limit their ability to Don’t be surprised if they’ve divided downgraded by Morningstar and Lipper.
market, measured by market capitalization, accounts meet their goals. If they’re their deferred salary equally, either He agreed. The fund filled a gap in his port-
for just 44% of the total global equity market, accord- comfortable with your ability among all of the fund choices avail- folio and was undervalued. But, at the last
ing to data compiled by Russell Indexes. to protect their assets, and able in their plan or among the three minute, he recalled buying a faltering fund
Your clients aren’t the only ones who prefer invest- you’re patient enough, you may or four alternatives they’ve selected. that had continued to lose value, and he
ing in what they know. As John R. Nofsinger points out be able to tempt them with What that pattern demonstrates is a changed his mind. Ed’s regret aversion bias
in The Psychology of Investing, even sophisticated in- something a little more adven- commitment to diversification but not pushed him to avoid another mistake. But
stitutional investors predict that domestic companies turesome down the road. the knowledge to make it work. It’s when the fund’s value increased, he felt an
will provide higher returns than international ones— Coping with risk seekers the opening you need to suggest a even keener sense of regret because he’d
regardless of the country in which those professionals requires a different approach. better approach. trusted fear rather than reason.
live. It’s an example of a behavior called home bias. Since you’re unlikely to be
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 B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E

Behavioral Finance
(option b). But in the second group, 69% Behavioral economists who analyze
chose option (b) indicating that they were the power of framing also point out
willing to assume the greater risk of losing that the way people hear what is being
$1,000 rather than face the certain loss said—in addition to the way the alter-
Intuition and emotion play a major role in decision-making. of $500, a result that has been validated natives are expressed—impacts the
in subsequent tests. The study generated decisions they make. Typically, their
The origins of behavioral finance are ways: one a “rapid, associative, automatic years of additional investigation and more perceptions are influenced by their recent
rooted in cognitive psychology, which and effortless intuitive process” and the evidence about why investors behave the past experiences, associations, intuitions,
is the study of how people learn, what other “slower, rule-governed, deliberate, way they do. One of the key findings was and a range of other factors that may
they know, and how they act on what and effortful.” The second judgment that prospective losses bother investors or may not include a conscious effort to
they know. process, he says, recognizes that the first much more than prospective gains make a rational decision.
As the field evolves, its focus has approach sometimes results in errors and please them.
been and continues to be on two may or may not overrule it. According to Kahneman, their OPENING MENTAL ACCOUNTS
related phenomena: work on this topic, which they labeled The concept of mental accounting, which
THE PAIN OF LOSS “Prospect Theory,” also made it irrefu- Thaler called narrow framing, describes
• Why people, faced with investment
and other financial decisions,
In 1979, Tversky and Kahneman published tably clear that the choices people an approach many people use to organize
a similarly groundbreaking study of the make are based on their subjective ver- their financial assets in their minds, cre-
make the choices they do
powerful impact that aversion to loss has sion of the situation, not on some ating separate compartments for money
• How choices are, and can be,
influenced
on people’s financial decision-making. objective reality. they’ve designated for specific purposes
and refusing to mix and match. For exam-
ple, they might segregate what they need
Those interests are built on the
four cornerstones of the field: an PROSPECT FRAMING for living expenses in one mental account,
understanding of heuristics, prospect THEORY money to buy a home in another, money
invested for specific long-term goals in a
theory, and the concepts of framing
third, and money for vacations in a fourth.
and mental accounting.

MENTAL
Tversky Kahneman
HEURISTICS ACCOUNTING Thaler

SHORTCUTS TO CHOICE When mental accounting works, it

Amos Tversky and Daniel Kahneman, In one of the experiments conducted FRAMING DECISIONS keeps investors from borrowing from
psychologists whose research laid the in their research, one group of partici- It’s not what you say, it’s how you say it. their 401(k) account to spend it on a
groundwork for behavioral economics, pants was told they had $1,000 and were This adage has taken on new meaning in vacation. But being too rigid can lead
concluded after investigating decision- asked to choose between (a) a sure gain behavioral finance where it is becoming to poor choices, sometimes involving
making in a variety of settings, that of $500 and (b) a 50% chance to gain an increasingly clear that the ways in which significant amounts of money. For
many people use heuristics, or mental additional $1,000 and a 50% chance to alternatives are presented to people can example, consider a person who chooses
shortcuts, to arrive at intuitive con- gain nothing. make substantive differences in the to finance a car rather than purchase it
clusions based on limited and often A second group was told they had financial choices they make. The way outright with money available in a savings
unreliable information. $2,000 and were asked to choose between that things are presented is known account because the account has been
When these findings were published (a) a sure loss of $500 and (b) a 50% as framing. designated for another use in a mental
in 1973, they evoked outrage in some chance to lose $1,000 and a 50% chance One often noted example of framing accounting system.
quarters—and accusations that Tversky to lose nothing. involved representatives of the credit As an advisor, you might point out
and Kahneman were arrogantly condemn- The results of either choice posed to card industry who, faced with justifying that a client who has the discipline to
ing people for not thinking straight. But the two groups are identical: in choice (a), higher charges for purchases made by repay a lender could borrow the purchase
further study has confirmed not only the
existence of mental shortcuts but also
their impact on decision-making.
participants end up with $1,500, and in
choice (b) they end up with either $2,000
or $1,000. Despite the identical end
card than those paid for in cash, preferred
to account for the price differential as a
cash discount rather than what it really
part of the principal plus market-rate
interest each month. But you might have
%
amount from his or her savings and repay

Kahneman himself elaborated on results for the first and second groups, was—a surcharge to help cover credit to overcome the objections of a mental
this idea in 2002 when he observed that 84% in the first group selected the known processing fees. accountant to succeed.
human judgments can be produced in two gain (option a) rather than risk a loss
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 B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E
interplay of the quick, reflexive
A Glimpse Inside the Brain instincts of the limbic system and
the reflective, analytical powers
of the cortex.
A UNIVERSE UNTO ITSELF
Researchers caution that while imaging and
Neuroscience provides key insights into how investors make other techniques yield important clues about
the brain, these methods only afford a glimpse into
financial decisions. TOOLS OF THE TRADE
enormously complex brain processes. Neuroscientists
Neuroeconomists use an array
of methods to study how the estimate that the human brain contains 100 billion
Many of the principles of behavioral clear of danger, and to survive. However,
brain works, including: neurons—roughly equivalent to the number of stars in
finance are finding validation in neuro- the same instincts that enabled pre- the Milky Way.
science —the physiological study of the historic people to prevail may make Brain imaging. A variety These neurons create intricate networks that control
brain and nervous system. While human people less successful at dealing with of imaging technologies all physical and mental processes. In fact, many
beings have speculated about the brain the risks, rewards, and challenges of enable scientists to visually scientists agree that the human brain is the most
and consciousness for thousands of years, modern-day financial markets. map brain activity in response complex and sophisticated phenomenon
recent breakthroughs in brain imaging to different thoughts, feelings, in the known universe.
and other techniques provide insights CHECKS AND BALANCES and actions. The oldest is the electro-
into how the brain actually functions. Both the limbic and cortical areas of encephalogram (EEG), which measures
An emerging field called neuro- the brain play a critical role in making electrical activity in
economics, which combines brain financial decisions. The limbic impulses the brain. Another One recent and
studies with psychological research and that helped early humans survive can technique, positron widely used technology
economic theory, is reshaping how many lead modern investors astray if those emission tomo- is functional magnetic resonance
financial experts think about the way impulses go unmediated or are so strong graphy (PET) imaging (fMRI), which records changes
people make financial decisions. that they override the powers of reason scanning, mea- in magnetic properties that occur in brain
and analysis arising in the cortex. For sures blood flow. cells due to blood
MIND AND MONEY instance, emotional urges originating in oxygenation.
Many of the emotions, biases, and the limbic system can cause investors Because brain cells
thought processes that contribute to to panic and liquidate their portfolios consume oxygen
financial decision-making have origins during a temporary market downturn. when they are
deep inside the brain and in the network On the other hand, investors who active, fMRI can
of communications between different ignore their instincts altogether and rely help researchers
parts of the brain. Understanding some-
thing about these neural foundations
solely on calculation and analysis may
also go astray in the financial markets.
Instinct & pinpoint areas
and patterns of
can help advisors work with clients more
effectively in making money management
As many successful investors attest,
intuition—the unconscious ability to
analysis brain activity.

and investment decisions. process key information instantane- work together Single neuron
measurement.
The human brain has evolved over
hundreds of millions of years to deal with
ously—also plays an important role
in investment decision-making. to balance Even the most sophisticated
imaging techniques can measure
the life-and-death struggles that homo
sapiens and their ancestors faced: to find
In fact, many neuroeconomists
agree that a successful approach
investment activity only in brain circuits, made up
food and shelter, to procreate, to steer to investing arises from an ideal decisions. of thousands of neurons, or nerve cells.
Single neuron measurement
enables scientists to track
individual neurons. However,
ANATOMY OF THE HUMAN BRAIN because single neuron recording
Broadly speaking, the human brain can be The innermost and oldest part of to sudden reactions and quick techniques are very invasive, this
divided into three areas, each responsible the brain is the midbrain, which is value judgments. research is performed only on
for different neural processes. responsible for regulating vital functions, The large outer lobes of the brain laboratory animals. As a
such as breathing and body temperature. make up the cortex, responsible for result, it has so far
It is sometimes called the reptilian analytical thinking, calculating, yielded more insight
brain because it reached its most planning, and learning. It is estimated into the basic drives
CORTEX
advanced stage of evolution in reptiles, to have emerged in primates about two that humans share
about 250 million years ago, and includes million years ago and is most evolved with other animals
the same structures that dominate the in human beings. than into the neural
brains of present-day reptiles. A hundred trillion neural circuits processes that are unique to humans.
Above the midbrain is the limbic traverse the brain enabling the three
Study of neurological disorders and
system, which is believed to have anatomical areas to communicate with
damage. The study of brain activity in
emerged about 150 million years one another. For example, the cortex
people who suffer from neural damage,
ago and is common to all mammals. processes emotions and sensory data
developmental disorders, and mental
LIMBIC The limbic system is the emotional emerging from the limbic system.
illness can also provide important in-
SYSTEM center of the brain and the source To illustrate, if the limbic system
sights into brain function. For instance,
of powerful unconscious motiva- perceives a reward like food or
scientists glean information about brain
tions. It’s the reactive part of shelter—or the potential return
MIDBRAIN processes by comparing the brain activity
the brain that processes informa- on an investment—the cortex can
of people who have neurological damage
tion instantaneously, leading decide whether it’s worth pursuing.
to those who don’t.
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 B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E

When the processes…

Neuroeconomics …Work together …Don’t work together
Studies of the brain are transforming long-held assumptions
about financial behavior. NTROLLED NTROLLED
O O

C
While economists have long recognized instinctively, effortlessly, and below
that emotions play a role in financial the level of conscious awareness. These
decisions, they have generally excluded processes, many of which humans share
feelings, impulses, and biases from their with other animals, have been essential CONSCIOUS
theoretical frameworks because emotions to human survival. They include reflexive
couldn’t be measured objectively or reactions to strong emotions, such as
AWARENESS
represented mathematically. desire, aversion, excitement, anger, fear, LEVEL
Neuroeconomists, on the other and panic.
hand, offer a different perspective. They Automatic processes are also
AU AU
T O M AT I C T O M AT I C
measure what happens inside the brain responsible for the immediate instinctive
when people make financial decisions. judgments that take place viscerally—
And what their research has shown is that well before a person consciously
decisions that appear to be inexplicable
or irrational often occur because of
acknowledges that someone or something
is good, bad, desirable, funny, or sad.
Effective Response Problematic Response
hard-wired human traits deeply rooted When automatic processes encounter
in brain structure and function. unanticipated events or choices, or are interesting from a financial perspective, inexplicable reason, act against their
These insights have not only revolu- faced with complex decisions, the brain’s however, is that in certain cases the better judgment and spend money
tionized thinking on the theoretical controlled processes take over. In con- two systems may compete rather than intended for long-term goals to gratify
front, as economists have been spurred trast to automatic processes, controlled collaborate with each other. For example, immediate desires.
to develop more comprehensive frame- processes are conscious, deliberate, if a situation is vague or ambiguous, or These overriding instincts—away from
works for explaining financial behavior. and strategic. Traditionally, financial evokes strong emotions, the reflexive apparent risks and toward immediate
They can help you as an investment decisions, such as planning for short- and urges arising from the brain’s automatic gratification of goals and desires—helped
advisor help your clients recognize and long-term goals, choosing investments, processes may dominate and override prehistoric humans prevail in an age when
manage their primal motivations and and deciding if and when to buy or sell, more deliberate controlled processes. the ability to quickly assess and respond
feelings so they can make smarter are associated with controlled processes. This phenomenon may explain why, to danger or to seize an opportunity were
investment decisions. for instance, many investors who are matters of life and death. These same
EMOTION VERSUS REASON faced with uncertain situations, such as instincts, however, can be problematic
AUTOMATIC PILOT In most circumstances, the automatic market downturns, react in panic and be- for investors and their advisors since
Neuroscientists have found that the brain and controlled systems work together to have counter to their established financial they tend to upend long-term financial
is largely designed to carry out certain react to emotions, draw conclusions, and plans. There may be a similar explanation planning and investing to meet
automatic processes that take place respond effectively to situations. What’s for investors who, for some seemingly specific goals.

THE REWARD SYSTEM brain’s reward system, can cause inves- physical sensations, such as sweaty hold disappointing investments
The pursuit of reward and the avoidance tors to jettison their long-term objectives palms, elevated heart rate, and shallow too long because they are
of risk are two of the central goal-oriented in pursuit of instant gratification. It can breathing. Called the loss avoidance afraid or unwilling to take
systems within the brain, underlying much also precipitate greed, causing investors system, this chain reaction can have losses. In addition, loss
of human feeling, thought, and action and to overtrade, invest on impulse, and lose many detrimental effects for investors avoidance can inhibit
provoking powerful biochemical processes sight of their strategy and objectives. who haven’t developed strategies for the innate intuitive
that affect the entire body. managing stressful situations or dealing intelligence that
When the brain perceives something THE LOSS AVOIDANCE SYSTEM with investment risk. effective inves-
it desires, from a delicious meal to a new Similarly, when the nervous system For instance, loss avoidance may tors value so
car, it releases dopamine—sometimes senses something threatening in the prevent investors from taking the risks highly.
known as the brain’s pleasure chemical. environment, the brain secretes adrena- necessary to meet their long-term finan-
This powerful biochemical induces line and other stress hormones into the cial goals. It may also compel them to sell DEVELOPING EMOTIONAL
sensations of happiness, arousal, and bloodstream, giving rise to feelings of their investments at the slightest sign of INTELLIGENCE
alertness as it directs the attention of anxiety, fear, nervousness, and the so- a setback, causing them The good news is that investors can develop
the nervous system towards the pursuit called fight-or-flight response to to miss out on long- techniques to help them respond more
and attainment of the desired goal. perceived dangers. term gains, or to effectively to stressful feelings and deep-
In financial contexts, however, these The flood of stress hormones seated impulses. By cultivating intellectual
Y
RO
CK

urges, which neuroeconomists call the throughout the body can also discipline, flexibility, and self-knowledge, by
AD

cause unpleasant
RO

learning to accept loss, and by setting realistic

DEAD
LONG-TERM END AHEAD
and concrete goals, investors can go a long
way to developing the emotional intelligence
OBJECTIVES that is a linchpin to investing success.
HIGHWAY GOAL SIGHTINGS
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Investor Biases
TAKING A NARROW VIEW or low toward their long-time average, and
Biases tend to exert themselves in situ- so may not make the same mistakes as
ations that are uncertain or emotionally new investors. But experienced investors
Short-cuts can save time but charged—and investing is both. The aren’t immune to probability bias.
ups and downs of the financial markets Try asking a cross-section of clients if
they can send you down the are unpredictable, and few things evoke they’re more concerned about running
wrong road. stronger feelings than one’s own money. short of money in retirement or being
Investors are especially vulnerable wiped out in a market crash.
to biased, or distorted, perceptions of While either is possible, it’s certainly
Think about the torrent of sensory data
probability and the way it affects much more probable, based on historical
that floods the human brain and nervous
investment risk. and anecdotal evidence, that inflation is
system every moment of every hour.
Think about what happens at a basket- the greater threat to financial security.
Even when you walk down a city street
ball game when the star player sinks three Yet the possibility of a crash tends to grip
on your lunch hour, you’re processing
field goals, one after the other, as the investor emotions in a way that inflation
enormous amounts of information from
clock runs out. risk does not.
your environment—reacting to the
The crowd,
weather, evaluating sights, smells, sounds,
caught up in THE STING
and the body language of passers-by,
the energy of OF BIAS
negotiating traffic at crosswalks. You’re
the moment, Do you have clients
also constantly surveying your surroundings
is absolutely who lost money
for potential threats—such as speeding
convinced when the technol-
vehicles—and rewards, like the salad or
he’s on a roll ogy bubble burst in
sandwich you plan to buy for lunch.
and can’t miss the next shot—especially 2000 and who still
It would be impossible to perform even
if it will win the game. You could never refuse to invest in
the simplest tasks or make the most basic
persuade them that, despite the player’s tech stocks? This bias—called the snake-
judgments if you had to work through all
obvious skill, hitting the fourth is no more bite effect—makes your clients unable
of these cues consciously and deliberately.
or less probable than his hitting the first to see that the risks and rewards of the
That’s why the human mind reacts very
one was. sector are completely different now than
selectively to the information it takes
It’s the same kind of enthusiasm for they were at the beginning of the century.
in, by employing shortcuts and rules of
what is possible but not probable that And it may be preventing your bite-shy
thumb to arrive at conclusions, evaluate
drives some of clients from taking advantage of strong
potential risks and rewards, and assess
the investment growth opportunities.
choices certain On the other end of the spectrum is the
clients make bias known as the house money effect,
when they mis- an expression borrowed from the world of
take a recurring casino gambling.
the likelihood of particular outcomes.
pattern as a Like inexperienced
Psychologists and behavioral economists
predictor of future results. Why do they gamblers, investors
call this process heuristic simplification.
gravitate to last year’s best performing may be inclined
fund or this year’s hot commodity if it’s to take excessive
ORIGINS OF BIAS
not that they expect the magic to last? risks shortly after
The use of such shortcuts can make people
experiencing an
act in apparently irrational ways, because
MISDIRECTED WORRY investment windfall. Because your clients
their past experiences, their feelings, and
More experienced investors understand haven’t assimilated the earnings as their
their intuitive sense of what is pleasurable
the tendency of fund performance or com- own, they tend to take greater and often
or painful influence their decisions. The
modity prices to move from a current high ill-conceived risks, veering far off strategy.
result of all this is bias.
These actions typically result in steep
Everyone has biases. You may find the
losses. Researchers have identified
World Series exciting and the World Cup UNREPRESENTATIVE SAMPLE
the house money effect among a wide
tedious, or the reverse. You may put New After the back-to-back experiences of variety of investors, from individuals to
York at the top of your destination list or winning big in Las Vegas and accumulating professional traders.
relegate it to dead last. You may love or impressive gains in the two technology The snake-bite and house money biases
hate jazz, drink red but not white wine, stocks in his portfolio, Tim was on a roll. resemble another important bias known
and despise beets. Convinced his lucky streak would hold, he as representativeness, which results
Most people think of these seemingly told his advisor to sell his underperforming in investors labeling an investment as
irrational judgments as benign, but they assets and buy more technology stocks. good or bad based on its recent perfor-
can exert enormous influence on feelings, Tim not only increased his risk by reducing mance. It’s a bias that helps to explain
thoughts, and actions. And when these diversification. He made the error of why investors predictably break the
cognitive shortcuts are applied to personal calculating probability based on a too-small golden investment rule. They buy stocks
finances, they can lead investors away sample size. Heady from his success, he whose prices have risen, expecting those
from rational, long-term thinking to highly ignored the realities that not all technology increases to continue. And they ignore
charged and prejudicial reaction that falls companies perform the same and no sector stocks—or sell at a loss—when their
back on preconceived notions and old is hot forever. prices are below their fundamental values.
patterns of thinking and problem solving.
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Types of Biases
sentativeness, which overemphasizes
A RECENCY REACTION
RCONFID current experience as an indicator of
VE the future. In September 2008, as the government
O struggled to resolve the sub-prime debacle,
Loss-averse clients also tend to be
Biases explain why some people are risk-

EN
vulnerable to the endowment effect, Janice asked her financial advisor to

CE
averse and others take excessive risks. which means they want to keep invest- liquidate any holdings that exposed her
ments they already own. In fact, this bias to the financial services industry. She saw
may help explain why many investors the takeover of Fannie Mae and AIG and
The challenge of helping clients overcome the collapse of Washington Mutual as a
consider sell decisions harder to make
the biases that limit their investment signal of continuing crisis. Her recency bias
than buy decisions. Their emotions are
success is complicated by the conflicting prompted her to overrule the historical data
involved when they sell.
emotions that drive their behavior. that suggests that well-chosen undervalued
BIASES OF SOCIAL INTERACTION securities may be wise investments that can
BIASES OF SELF-DECEPTION enhance a diversified portfolio.
Their social environment and personal
Biases of self-deception stem from the
interaction also exert powerful influences
fact that the great majority of people
on your clients’ investment decisions.
think they are better, smarter, and wiser
Because people have trouble processing This example helps to explain the
than they really are. In a frequently
all the information they’re bombarded bandwagon effect, or why individuals
cited example, as many as 80% of drivers
with, they tend to pay much more atten- are driven to follow market trends—
believe they are more skilled than the
tion to opinions or facts that they can resulting in financial bubbles and
average driver. Of course, many must be
confirm with people they know or their subsequent bursts—in the absence
fooling themselves, since statistically,
own experience. So, for instance, they’re of the fundamental data or analysis to
only one-third can be above average.
more inclined to invest in a stock they’ve support their decisions.
This bias, known as overconfidence,
heard about from others.
leads investors to:
Another way that social interaction COGNITIVE DISSONANCE
• Believe that their judgment is better • Illusion of control. Overconfident plays a critical role in investing is known People are uncomfortable if they have to
than it really is as herding. Like other social animals, hold two contradictory ideas in their mind
investors believe they can exert
humans instinctively follow the behaviors at the same time. So they either reconcile
• Think they have access to better influence over uncontrollable events.
and opinions of the majority to feel safer the opposing positions or accept one and
investment information than others
• Self-attribution. These clients tend and to avoid conflict. If the majority of the reject the other.
• Be overly optimistic about the to attribute successful outcomes to group starts to move in one direction, the For instance, how do your clients re-
outcomes of their investment choices their own skills while blaming poor others instinctively follow. spond if the average historical return for
results on bad luck or you. In fact, studies show that the brain the stock market is 10% but their portfolio
In fact, overconfidence is especially
actually secretes a chemical to the pre- return has been negative for the past
prevalent among experienced investors, • Hindsight bias. They convince them- frontal cortex to create pain in the brain three years? They may acknowledge that
which typically means they buy and sell selves, contrary to fact, that they had
if you are forced to go against the crowd. long-term market performance smoothes
too often—increasing transaction costs predicted poor outcomes, making it
That may explain Solomon Asch’s famous out short-term volatility and use the most
and reducing returns—and take excessive likely they’ll repeat the same mistakes.
study on social conformity, where he recent three-year market performance
levels of risk.
asked test subjects which of the three as the benchmark for their three-year
You can counteract overconfidence BIASES OF FEAR AND REGRET
lines in the box to the right is equal in returns. Or, they may reject one of the
more effectively if you recognize some of Nobody likes to lose money or make in-
length to the line in the box to the left. contradictory ideas.
its chief warning signs: vestment mistakes. But some clients are
The one they reject has a lot to do
FEAR so afraid of doing the wrong thing that
with their self-perception. If they think
they put their money in cash or govern- ASCH LINES
of themselves as good investors, they may
ment securities and leave it there because
rationalize away their bad recent perfor-
they’re emotionally incapable of making
mance or ignore it altogether, filtering
choices and too nervous about stocks.
out all but the positive aspects of their
For these investors, avoiding loss takes
decisions. In contrast, if they perceive
precedence over pursuing investment
themselves as poor investors, they may
gains, even when the losses are short term
believe they are always doomed to under-
and the possibility of gain is long term.
perform the market.
Risk-averse investors, when they do
Cognitive dissonance can affect
buy, tend to get into the markets too
investment decisions in other ways as
late and miss out on gains. They’re also
well. For instance, some of your clients
vulnerable to panic selling in the face of A B C may put off making difficult decisions to
losses—unless you recognize the symp-
avoid the discomfort of internal conflict,
toms and persuade them to wait.
such as making financial sacrifices now to
These actions are the result of what’s Thirty-two percent of those tested said
save enough for the future. The distorted
known as projection bias. In periods the answer was B, even though it’s obvi-
perceptions that arise from cognitive
when the markets are strong, risk-averse ously wrong. The reason? A majority of
dissonance not only get in the way of
investors anticipate future strength. But the group were fake participants planted
clear-headed evaluation of investment
in periods of turmoil, they fear worsening to say the wrong thing. The conclusion?
choices. They foster a tendency to
losses. This response is driven by what’s People were more willing to follow the
continue to make the same mistakes.
known as the recency effect, or repre- majority than to think for themselves.
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B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E

Mental Accounting from the client’s own account to

illustrate the downside of thinking too
ortable, or what is known as anchoring
or home bias. This tendency helps to
narrowly. In most cases, you don’t have explain why people buy the stock of the
Looking through a different frame alters your perspective. to look any further than the capital gains company they work for—both inside
in their year-end account summary, and outside their 401(k)—ignoring the
Retirement savings plans are a great a house. Shares of stock A are one invest- pointing out that the tax they’ll owe on double hit to their financial security that
success. When a plan is available, the ment and shares of stock B are another. their gains, especially in the absence of problems in the company would cause. It
majority of employees sign on. When This tendency is hardly surprising offsetting capital losses, is money they also explains the reluctance of people in
there’s an employer match, many and it doesn’t exist in a vacuum. The could have put to effective use in one country to invest in the markets of
contribute enough to qualify for the US tax code provides advantages for making new investments. other countries, even when those markets
full amount. By using automatic putting money in retirement or education are strong and growing stronger.
enrollment to bring non-participants savings accounts and penalizes early But be prepared. Determining correla-
into the fold, employers do an end-run withdrawals. Intentionally or not, this

us all in mind tion and thinking globally rather than

Keep
around procrastination. And, by adding fosters the notion of separate and locally are things most of your clients
automatic escalation clauses and unequal investment accounts. probably can’t or won’t do on their own.
default investments, they take most Similarly, some economists argue, the So you’ll have your work cut out for you.
of the stress out of investing. corporate practice of paying dividends
Increased participation is good encourages mental accounting because REBUILDING THE FRAME
because it improves the likelihood that it encourages shareholders to see invest- Countering mental accounting is all
more people will have greater financial ment earnings as separate from invest- about looking at the big picture and
security after they retire than they ment principal. Like a bonus, a gift, or Stocks taking the long view. If the statements
would otherwise enjoy. even a tax rebate, the dividend is found your clients receive report performance
But there’s an irony in this story. money that can be spent without qualm Down from month to month rather than from
Certainly it’s smart to find painless even by an investor who refuses to cash in Payment an account’s inception or an investment’s
ways to counteract the emotions that a CD paying 4.5% interest to pay off credit transaction date, you’ll serve them and
Savings
lead to bad investment choices like not card debt that carries an APR of 19.5%. Retirement your relationship well if you generate a
participating in a retirement savings companion report with a five- or ten-year
plan. Yet focusing so much attention TWO POINTS OF VIEW Fund perspective, or longer. It’s much easier
on the single goal of investing for Unlike following the herd, fearing a snake- to be persuasive about bad investment
retirement encourages the practice bite, or other investor biases, mental decisions that are based on short-
of mental accounting, the most accounting has advocates. Successful bud- term fluctuations when you have
common and in some ways the most geting depends on it. So does resisting long-term evidence to back up your
self-defeating investor bias. the temptation to tap your home equity for point. And they are much less liable to
a blowout vacation. But while allocating be distracted by small gains or losses if
PART OF THE FAMILY
OPENING MENTAL ACCOUNTS money to specific uses may be essential they take a broader view of their wealth.
The larger challenge is persuading
Mental accounting, like other forms of for self-control, it’s also a mental shortcut
your clients—from the newest to the
accounting, means people assign their that can limit investment return.
most experienced, from the most risk
financial assets to separate categories At the most basic level, mental
averse to the most overconfident—to
in their minds rather than treat them accounting explains why loss-averse
make correlation with existing assets
as components of a single portfolio. investors are reluctant to sell under-
Retirement assets are for retirement. performing securities, not only tying up
a primary consideration when they buy
securities or add investment options to 10
Down payment savings are for buying money that could be more profitably
their goal-specific accounts. The point is years
invested elsewhere but also failing to
that making piecemeal choices, however
accumulate capital losses that could
strong they may be individually, inevita-
reduce their tax bills. This happens be-
bly limits long-term investment success.
cause they weigh the loss solely against
A complicating factor is that most
the security’s purchase price, and selling
people build their investment portfolios
would put that balance sheet in the red.
incrementally, with a combination of
It also helps to explain why investors
reinvested earnings and new money. In
tend to sell their strong performers too
choosing investments, they’re likely to
soon. Instead of considering the gains
be drawn to what is familiar and comf-
a profitable security could add to their
overall wealth, they sell because they
can book the transaction in the
plus column.
The advantage of investment
errors like these is that you can
actively intercede by using evidence y

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Action Plans C PUTTING EXPECTATIONS IN PERSPECTIVE

Nothing feeds investor fear, exuberance, panic, or
There’s nothing wrong with making mistakes. The problem greed—or the mistakes those emotions generate—
more intensely than checking the market
is making the same ones over and over. day-to-day or even hour-to-hour. One of the
greatest contributions you can make as an
If you understand why your clients make That may not seem radically different advisor is to redirect that myopia to a long-
some of the poor decisions they do, you from the approach you’ve always followed. term perspective that starts at the point your
can move your relationship with them But it has a more clearly defined purpose: client opened his or her account and ends
to a new, more productive level by overcoming investor biases to improve ten years or more into the future. Along that
helping them: investment performance. arc, even a substantial loss in portfolio value
from one month to the next is a minor blip,
A Define a personal risk policy not the end of the world.

B Develop an effective
investment strategy By providing rational and consistent which can wipe
B DEVELOP A STRATEGY
With a risk policy in place, the criteria for these decisions, you can out small profits,
C Maintain a long-term perspective next step is helping clients define help counteract subjectivity and bias, but also reduces BUY
their investment philosophy—which streamline the decision-making process, the high cost
is why they’re investing—and develop and improve bottom lines. of too many
A CREATE A RISK POLICY an investment strategy built on the short-term capital
Instead of trying to pinpoint three pillars of investment success: A PLAN TO SELL gains. You might SELL
risk tolerance—a notoriously un- Deciding when they’ll sell before even suggest that
reliable exercise—you may want to 1. Choosing securities
they buy may strike some clients as a small victory
shift your focus toward developing 2. Constructing a portfolio irrational. But like a prenuptial agree- over the IRS can be a satisfying
a pro-active risk policy for each 3. Determining when to trade ment, which deals head-on with the antidote to the emotional rollercoaster
client that’s appropriate to his or financial consequences of a potentially of constant trading.
her age, goals, financial situation, poor choice of partner, a plan for selling
and investor psychology, which is can counter what behavioral economists DEALING WITH
based on emotional responses to Meir Statman and Hersh Shefrin have SETBACKS
the uncertainties and opportunities labeled the disposition effect. It’s the If you’ve done your
of investing. tendency for investors to hold onto poor job in stressing the
A risk policy can guide you as you investments too long and sell good ones uncertainty that’s

1 2
structure the client’s core portfolio too soon. always part of
of broadly diversified equity invest- Typically, these decisions are driven investing, your
ments chosen for their by the emotions of pride and regret clients shouldn’t be
long-term rather than logic and rationality. If surprised if their portfolios drop in
promise. The first two are undoubtedly part you can demonstrate in dollars and value from time to time or a security
This will of the advice your clients have come to cents the impact that holding onto disappoints. But you have to be
help you expect from you. As you increase the disappointing investments while selling prepared for their emotions to inter-
identify the emphasis you put on the third pillar, profitable ones can have on portfolio fere with their logic.
appropriate here are two approaches that can make performance, you’ll have a useful Getting them to think ahead about
role for the a difference: weapon to counteract these client how they’ll respond to inevitable set-
more fluid and
more actively • Give as much attention to what emotions when they inevitably occur.
One way of doing this is to pull
backs is key to a long-term successful
relationship. So is emphasizing the
and when to sell as to what and
managed group an historical performance chart for difference between losses that are the
when to buy
of satellite in- a solid but particularly volatile stock result of a falling market and those
vestments that • Lay out a plan in a client’s portfolio. Discuss what that are the result of bad choices.
supplements or enhances that core. to handle you anticipate will be a continuing You’ll discover that it’s generally
For example, for a client whose setbacks pattern of price fluctuations. Address much easier for them to accept the
tendency is to panic in the face of the emotions of greed and fear that merits of planning to buy on market
market volatility, you may use the such gains and losses typically foster dips—which they may have resisted
satellite investments to reduce risk in investors. This may help your client doing in the past—than it is to
exposure even if it means limiting resist the emotional pull to take quick recognize the limitations of intuition.
the potential for gains. Or, for a profits at the expense of the potential Intuition has its place, but it should
client who relishes being on the for long-term portfolio gains. be balanced by understanding the
cutting edge or whose investment

3
As you craft a selling strategy with mental shortcuts that interfere with
timeframe requires an above average them, to remind your clients that limit- sound decisions.
return, you can use the satellite ing the amount of trading they do not
investments in the active pursuit only helps to limit transaction costs,
of risk.

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Redefining Advice conduct this type of dialogue on their

own as part of making future decisions.
The advantage for you is that you
understand why you’re concerned about
decisions they’re making. By encouraging
them to put themselves in your shoes,
Looking through the prism of behavioral finance provides a can continue to hone your ability to you’re on firmer ground in urging them to
anticipate problems and the solutions do what you say rather than what you did.
new view of your role as advisor. you offer. Both make you a better Similarly, keep a running record of
advisor. For example, if a client’s the advice you give, with an explanation
Your challenge as an advisor is antici- concern is retirement income you of why you’re giving it, and how clients
pating, recognizing, and managing the READ THE WRITING may find it easier to encourage her to are responding.
emotions—anger, fear, regret, stress, increase her savings rate by focusing
greed, pride—and mental shortcuts ON THE WALL on the monthly income a particular
that interfere with your clients’ ability Here’s a list of client behaviors that, if account value will provide than on
to make rational and profitable invest- unchecked, threaten to undermine their the account value itself.
ment choices. financial security and your professional • Ask yourself if your enthusiasm for a
In describing this approach to advis- relationship with them. It’s smart to have CHECK THE MIRROR particular approach is too optimistic,
ing as “prescriptive,” Daniel Kahneman evidence, both anecdotal and factual, ready You can recognize client biases a bias that worries you when you detect
and Mark Riepe explain that its goal is to help counteract them: more easily if you keep a candid it in your overconfident clients.
to help you fine tune your approach to
your clients’ psychological profiles and
q Overtrading eye on your own investment
successes and failures.
• Evaluate whether you’re abetting a
tendency toward mental accounting
personalize your advice to improve their q Repeating the same mistakes, like Keep a list of your buy and sell by focusing on certain aspects of a
long-term investment experience. selling too soon, holding on too long, decisions—and those times when client’s financial situation rather
That advice may range from urging or buying too high you wished you’d bought or sold than looking at the full picture.
some clients to think twice before
they act—“taking a cold shower,” in
q Resisting diversification, often the
consequence of overconfidence or over-
but didn’t—and the reasons you
acted as you did. For those that • Reframe information as necessary
to motivate your clients to take a
Meir Statman’s metaphor—to helping valuing the familiar turn out to have been mistakes, try different, more desirable action.
others integrate the competing pulls to figure out if they were the result
of thoughtful analysis and intuition in q Mistaking naïve or indiscriminate of some mental shortcut or bias
making investment choices. diversification for the real thing whose influence you weren’t aware
The more finely you can tune your q Putting too much emphasis on of at the time.
advice to specific clients or groups of recent losses and not enough on In addition to what you learn about CALLING IT QUITS
clients who take similar approaches to long-term gains yourself from this analysis, you can use Are there clients you can’t help? There
investment decisions, the more effective your experiences to help your clients may be. And, in some cases, you may
q Blindly following the most recent
you can be in helping them achieve decide it’s wiser to end your relationship.
investment fad
their goals. And it’s no secret that in For example, the combination of optimism
helping them improve their investment q Nursing an obsession with avoiding loss THE BEST MEDICINE and overconfidence can be especially
experience, you benefit as well. If you can poke fun at your- difficult to counteract, as can “I knew
q Mental accounting
self by creating trophies better” hindsight that recasts your reason-
ASK FOR REASONS to the worst investment able suggestions as stupid mistakes. The
While the recommendations you offer in By working with them to analyze their decisions you’ve ever made, most untenable situations, however, often
this new environment may differ little decisions before they act on them, you you can take the edge off have less to do with the problems of bias
if at all from the advice you have always can point out the biases or emotions that the message that every- than with a major disconnect between a
provided, the more you know about are influencing their choices and what one makes mistakes and client’s stated goals and what
investor psychology, the more that knowl- a more appropriate response might be. emphasize that not his or her emotions
edge is likely to affect your one-on-one The back-and-forth should also encourage repeating them is what’s make it possible
interactions with your clients. them to internalize the really important. to accomplish.
For example, instead of commenting process, so that they’ll
directly when a client proposes buying or
selling a particular investment, you might
frame the discussion by asking:

• How did you decide on this

purchase (sale)?
• What were the alternatives
you considered?
• Why did you decide against
those and for this one?
• Can you think of any reasons
not to do what you’re planning?

ADVISOR
CLIENT
20 LOSS 21
 B E H A V I O R A L F I N A N C E B E H A V I O R A L F I N A N C E

Creating a
Checklist
If you want useful
answers, you need to
ask the right questions.
1. What about investing interests 5. What explains your investment disappointments?
Pinpointing the biases that
you the most?
interfere with your clients’ r Taking bad advice
ability to distinguish between a r Testing my skill
r Buying/selling at the wrong time
smart investment decision and
one that’s likely to undermine r Beating the odds r Lack of diversification
their return is an essential r Learning more about how r Bad luck
step in being able to make a the markets work
difference on their behalf. By
creating a profile for each person
r Nothing really, but I know
6. What are your investment goals?
I have to do it
or couple, you’ll be better able to
tailor an appropriate long-term r I never want to worry about money
investment plan. You’ll also be 2. What about investing concerns r I want to retire in style
better equipped to anticipate the
moments at which it would be
you the most? r I want to beat the market
smart to intervene. r Buying the wrong r I’m not really sure
Try adding some of these investments
questions to your customary r Missing out on investments 7. What would make you move your entire portfolio into cash?
assessment of where a client is I should have made
now, financially speaking, and
r Losing money r Losing my job
what he or she expects from
working with you. The answers r Nothing really, I’ve been r Too much volatility
can help you identify potential pretty lucky r The collapse of a big company
danger signs and frame your r Concern about a market crash
advice to counteract them. It
can also help cement your 3. How would you define a r Nothing
professional relationship. successful investment?
You may find that some 8. How often do you check how your portfolio is doing?
people don’t know how to answer
r One that I can sell quickly
for a big profit
some of the questions. Others r Once a year
may resist or say what they think r One that pays regular
r Most months, when I get my statement
you expect to hear, especially if dividends or interest
r Every few days
they feel they’re being tested.
One approach that may work in
r One that’s never going to r As often as I can
lose value
cases like that is incorporating
the questions into your ongoing r One where I guessed right
9. How many investment accounts do you have?
conversations rather than asking
them all at once.
It won’t surprise you to
4. What explains your r One for each of my major goals
know there are no right answers
investment successes? r Just this one, except for my retirement account at work
or that you’ll uncover some r The research I did r I don’t know off the top of my head
curious inconsistencies.
r The advice I got
r Going with my instincts 10. What’s your primary investment strategy?
r Good luck r Buy and hold
r I trade when a security gains or loses 20% over the price I paid
r I buy when I think a price is going up
r I trust my intuition
r I don’t think I have one

22
 G L O S S A R Y
Availability bias results in drawing Loss aversion is a compelling tendency
conclusions about the probability of to avoid realizing investment losses even
something happening based on the vivid when selling losers may have tax and
impression that a similar, often recent, other advantages.
event has made.
Narrow framing, or mental account-
Anchoring is the tendency to focus ing, is the practice of segmenting assets
on a single factor as the primary reason into separate buckets and treating each
for a decision or central explanation of bucket as a discrete entity dedicated to
an event. The factor may or may not be a specific use rather than as an integral
relevant, but it is never sufficient by itself. part of a total portfolio.
Confirmation bias propels people to Overconfidence bias results in
seek and overweight information that investors thinking they know more
confirms their views while avoiding or than they do or that they make better
underweighting what’s contradictory. decisions than they do. Among the
While this may be a deliberate attempt to consequences are the tendencies to
justify their opinions or decisions, such take more risk than is reasonable and
selectivity is often inadvertent. to trade too often.
Disposition effect describes the Pseudocertainty effect is the tendency
illogical practice of selling assets that to overemphasize a risk-free solution if
are performing well and holding assets that choice is available and to misjudge
that are losing value. It’s characteristic the relative probability of alternative
of loss-averse investors. outcomes when all the choices involve
risk. Often the resulting choice is not the
Endowment effect describes a situation best one available.
in which an investor is so emotionally
attached to an asset that he or she finds Projection bias undermines some
it difficult to sell even if that’s the people’s ability to do long-term planning
rational choice. because they are unable to image that
their needs or emotions will be different
Familiarity bias makes people favor in the future than they are in the present.
things they know over things they don’t Projection bias may also lead investors
know. It helps to explain why investors to assume that the way a security is
buy stock in local companies or those they performing in the present is the way it
work for and why they prefer domestic to will always perform.
international stock.
Recency effect leads people to put too
Herding is what happens when people much emphasis on current experiences
move as a group in one direction or or situations and not enough on long-
another. Like the bandwagon effect, term historical patterns. The result may
herding helps to explain market bubbles, a tendency to sell assets in a downturn
in part because of the emphasis on social or overbuy in a bubble.
consensus rather than analysis.
Representativeness is a mental
Hindsight bias allows investors to LIGHTBULB PRESS
shortcut that people take as they draw Project Team
believe that they predicted a poor conclusions about the future. They
outcome all along when they had not. concentrate on recent, often dramatic, Design Director Kara W. Wilson
It reduces the probability they’ll learn events as if they are not only normal but Editor Mavis Wright
from their mistakes. predictive. One consequence is buying Production and Illustration Thomas F. Trojan

House money effect describes what’s into securities after prices have already
SPECIAL THANKS
happening when people who’ve made risen substantially. John Aguilar, ING
money on their investments move into Self-attribution bias allows people Joe Hart, ING
riskier securities than they would have to explain investment success as the Bill Sigler, ING
chosen before their success. By way of result of their making smart choices
analogy, gamblers who bet their winnings and attribute investment failures to
©2008, 2009, 2014 BY LIGHTBULB PRESS, INC. ALL RIGHTS RESERVED.
www.lightbulbpress.com
are said to play with the house’s money. incompetent advice or bad luck. Tel. 212-485-8800
No part of this book may be reproduced, stored, or transmitted by any means, including electronic,
Illusion of control bias makes people Snake-bite bias leads people to shun mechanical, photocopying, recording, or otherwise, without written permission from the publisher, except
for brief quotes used in a review. While great care was taken in the preparation of this book, the author
believe they can influence the outcome of investment opportunities in sectors and publisher disclaim any legal responsibility for any errors or omissions, and they disclaim any liability
events even though their actions actually where they have previously lost signifi-
for losses or damages incurred through the use of the information in the book. This publication is designed
to provide accurate and authoritative information in regard to the subject matter covered. It is sold with
have no effect on what happens. cant amounts of money, even when the understanding that neither the author nor the publisher is engaged in rendering financial, legal,
accounting, or other professional service. If legal advice, financial advice, or other expert assistance is
that sector offers the potential for required, the services of a competent professional person should be sought.
strong positive returns.

24
A N A D V I S O R’S G U IDE T O B E HAV IO R A L FINA NCE
explores investor psychology from an advisor’s perspective. The
guide examines the causes of investor behavior and the biases
that undermine sound investment decisions, offering concrete
suggestions for addressing these biases. The guide also positions
investor psychology as a critical tool for enhancing client relation-
ships and building a business.

R A L F I N A N C E
B E H A V I O
R A L F I N A N C E e average, and
or low toward their long-timmistakes as
B E H A V I O TAKING A NARR
OW VIEW
lves in situ- so may not make the same nced investors

Biases
Investorsave
Biases tend to exert themse
ations that are
charged—and investi
uncerta in or emotio
ng is both. The
financial markets
nally new investors. But experie bias.
aren’t immun e to probab ility
Try asking a cross-section running
of clients if
time but
Short-cuts can ups and downs of the
few things evoke
they’re more concerned
about
ent or being
the are unpredictable, and short of money in retirem
they can send you down stronger feelings than
one’s own money.
vulnera ble wiped out in a market crash.
e, it’s certainly
Investors are especially tions of While either is possibl
wrong road. percep
to biased, or distorted, it affects much more probable,
based on historical
way e, that inflation is
of sensory data probability and the and anecdotal evidenc al security.
Think about the torrent investment risk. the greater threat to financi
brain and nervous s at a basket- tends to grip
that floods the human Think about what happen sinks three Yet the possibility of a crash inflation
of every hour.
system every moment a city street ball game when the star
player
investor emotions in a
way that
Even when you walk down field goals, one after the
other, as the
risk does not.
processing
on your lunch hour, you’re ation from clock runs out.
inform
enormous amounts of g to the The crowd, THE STING
your environment—reactinsmells, sounds, caught up in OF BIAS
weather, evaluat ing sights,
of passers-by, the energy of Do you have clients
and the body language the moment, who lost money
crosswalks. You’re
negotiating traffic at is absolutely when the technol-
ng your surroundings
also constantly surveyi as speeding convinced ogy bubble burst in
for potential threats—such the salad or he’s on a roll 2000 and who still
s, like
vehicles—and reward for lunch. shot—especially
and can’t miss the next refuse to invest in
sandwich you plan to
buy You could never called the snake-
to perform even if it will win the game. s tech stocks? This bias— clients unable
It would be impossible most basic
the player’
persuade them that, despite is no more bite effect—makes your
make the rewards of the
the simplest tasks or obvious skill, hitting the
fourth
to see that the risks and
to work through all the first different now than
judgments if you had and deliberately. or less probable than
his hitting
sector are completely
of these cues consciously reacts very ing of the century.
human mind one was. iasm for they were at the beginn your bite-shy
why the kind of enthus ting
That’s
ation it takes It’s the same And it may be preven
selectively to the inform and rules of probable that age of strong
what is possible but not clients from taking advant
ts
in, by employing shortcu sions, evaluate drives some of opportu nities.
the investment growth spectrum is the
thumb to arrive at conclu s, and assess On the other end of the
potential risks and reward choices certain money effect,
bias known as the house
clients make from the world of
expression borrowed
when they mis- an
gambling.
take a recurring casino
pattern as a Like inexperienced
lar outcomes. . Why do they gamblers, investors
the likelihood of particu economists predictor of future results performing may be inclined
ral
Psychologists and behaviosimplification. gravitate to last year’s
best
to take excessive
call this process heuris
tic
year’s hot commodity if it’s
fund or this
magic to last? risks shortly after
not that they expect the experiencing an e your clients
ORIGINS OF BIAS investment windfall. Becaus s as their
ts can make people
The use of such shortcu MISDIRECTED WORR understand
Y
haven’t assimilated the
earning
al ways, because greater and often
act in apparently irration feelings, and rs
More experienced investo ance or com- own, they tend to take
their past experiences,
their perform far off strategy.
the tendency of fund ill-conceived risks, veering in steep

• Pillars of • Risk Avoidance

e sense of what is pleasurable from a curren t high ly result
their intuitiv decisions. The modity prices to move These actions typical
influen ce their identified
or painful losses. Researchers have
result of all this is bias. among a wide
You may find the IVE SAMPLE the house money effect
Everyone has biases. UNREPRESENTAT individuals to
and the World Cup ces of variety of investors, from
After the back-to-back experien

Investment
World Series exciting and accumul ating ional traders .
. You may put New winning big in Las Vegas
profess money biases
tedious, or the reverse technology The snake-bite and house bias known
destination list or impressive gains in the two on a roll.
York at the top of your was le another important
You may love or stocks in his portfolio , Tim resemb
, which results
relegate it to dead last. would hold, he as representativeness
red but not white wine, Convinced his lucky streak investment as
hate jazz, drink in investors labeling an

Success
rforming
told his advisor to sell his underpe

• Neuroeconomics
and despise beets. on its recent perfor-
seemingly gy stocks. good or bad based
Most people think of these , but they assets and buy more technolo by reducing helps to explain
risk mance. It’s a bias that
irrational judgments as
benign Tim not only increased his ably break the
ce on feelings, error of why investors predict
can exert enormous influenwhen these diversification. He made the on a too-small investm ent rule. They buy stocks
calculating probability based success, he
golden
thoughts, and actions
. And expecting those
applied to personal whose prices have risen, they ignore

NTROLLE
cognitive shortcuts are sample size. Heady from his all technology And
increases to continue.
finances, they can lead
investors away ignored the realities that not and no sector hen their
rm thinking to highly stocks—or sell at a loss—w ental values.
companies perform the same
from rational, long-te
O D
fundam
cial reaction that falls forever. prices are below their
charged and prejudi is hot

• Mental
on precon ceived notions and old 13
back
problem solving.

C
patterns of thinking and

Accounting
12

Lightbulb Press, Inc. AU

www.lightbulbpress.com T O M AT I C
[email protected] Phone: 212-485-8800
• Framing
• Biases

VIRGINIA B. MORRIS

205 East 42nd Street, 20th Floor

New York, NY 10017
(800) 99-HERON
www.heronwealth.com