Behavioural Finance and Wealth Management: Understanding and Managing Investor Biases
Krishika Parekh
Entrepreneur | Passionate about making financial advice accessible and women empowerment | Building a responsible global wealth management platform using emerging?technologies
When it comes to managing wealth and making financial decisions, logic and rationality might seem like the obvious guides. However, the field of behavioural finance tells us that the frailer side of human psychology often takes the wheel, leading investors down a winding road of biases and poor choices based on emotions.?
Behavioural finance is the study of how psychological factors and emotions can influence the decisions people make about money and investments. As humans, we have cognitive biases that often lead us to make irrational decisions. Why? Because we're not always rational beings. Emotions, instincts, and social pressures frequently shape our choices.
Investing based purely on emotions is like sailing through stormy seas blindfolded. Fear and greed can drive impulsive decisions and this emotional rollercoaster rarely leads to financial success.
Herd Mentality?
One common cognitive bias in investing is known as herd mentality. This is the tendency of investors to follow what everyone else is doing, often without question. This can lead to bubbles in the market, for example, the dot-com bubble of the late '90s or the housing market bubble in 2008.?
Often, it's inexperienced investors and those who stand to lose the most that make up the majority of those following the herd mentality. Attempting to get rich quick by mimicking the strategies of successful investors, they often end up losing everything.
Interestingly, herd mentality actually has the power to drive market volatility. Perhaps the most famous recent example of this was the Robinhood and GameStop fiasco. Many people were left financially damaged or even ruined after a group of novice investors attempted to drive up the price of GameStop shares in a mission to punish the big Wall Street companies that had shorted the stock. This is a classic example of the herd mentality causing the herd to run off the cliff together.?
Over Confidence & Loss Aversion
Another very common investor bias is loss aversion. Humans are wired to feel the pain of loss much more intensely than the pleasure of gain. This bias can lead to missed opportunities, investing too conservatively or investors may hold onto losing stocks too long in the hope they'll rebound.
Panic selling is also a key component of loss aversion. Despite clear evidence that staying the course during market crashes has yielded far better returns for investors, panic selling during market corrections or crashes is an especially damaging result of loss aversion.?
An investor who kept their initial $10,000 in U.S. stocks for 15 years would have earned $24,753 more than someone who missed the market’s 10 best days, according to a Putnam Investments analysis through 2021. Omar Aguilar, CEO and chief investment officer of Schwab Asset Management, has commented that loss aversion “is a major reason why so many investors underperform the market.”
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In contrast to loss aversion, overconfidence is another cognitive bias that can get investors into trouble. This is a bias where people believe they're smarter and more capable than they really are. This can lead to risky investments based on inadequate research or assumptions about market trends.
Confirmation Bias
Confirmation bias is the inclination to seek out information that confirms what we already believe and to ignore information that challenges those beliefs. In investing, this can lead to ignoring warning signs about a chosen investment, resulting in losses. Research by Schwab Asset Management found financial advisors consider as many as 93% of their clients are affected by confirmation bias.?
Managing Investor Bias?
Understanding behavioural finance is vital for wealth managers, helping them manage biases that can greatly impact investment choices and outcomes. Through this understanding, wealth managers can provide informed guidance, and help clients avoid common pitfalls. Indeed, a study by Vanguard found that the most valuable role of finance professionals was as a behavioural coach, helping their clients to manage emotions during difficult times and keep them focused on their long-term goals.?
Behavioural finance can also be used to create tailored strategies that align with a client's individual psychology. By addressing specific biases, advisors can design investment plans that are more likely to resonate with clients and stand the test of time.
In the realm of wealth management, the role of behavioural finance is like a backstage pass to understanding the human side of financial decisions. By recognising and addressing cognitive biases, investors can strike a balance between the emotional and rational aspects of decision-making. Wealth management isn't just about numbers on a screen – it's about understanding the quirks of the human mind and using that understanding to navigate the complex world of finance.
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