TGBA # 28: Helping Clients Break Free from the Crowd

Welcome to the 28th edition of #theGoalsBasedAdvisor Newsletter!

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It is the time of year when the over-indulgence of the December holiday season is over and people’s thoughts turn to getting ready for summer beach weather. There is a renewed focus on healthier eating. And while there is plenty of information available online, recent studies have found that social relationships and media influence were key motivating factors for following unhealthy dieting methods.

This phenomenon of social influence is everywhere; it echoes in the most unexpected corners of society, much like the paradox surrounding women's rights in Saudi Arabia.

Interestingly, a recent Gallup poll revealed that a majority of Saudi men support women's rights, yet traditional norms persist due to the mistaken belief that others don't share this sentiment. This collective misperception can have profound implications, and it applies not just in societal contexts, but also in the financial world. As financial advisors, we often encounter a similar scenario.?

The Bernie Madoff Paradox: A Lesson in Herd Behavior

One of the most famous examples is the Bernie Madoff scandal. His outsized returns turned out to be fabricated, revealing the dangers of confirmation bias and social group comparison. Investors wanted to believe in consistent above-market returns, relying on the fact that members of their social group had invested with Madoff. This tendency, rooted in our inclination to seek validation from the perceived majority, poses a significant risk to financial well-being.

Academic research highlights the dangers of succumbing to social proof in investment decisions. In the complex landscape of financial decision-making, the influence of others can often sway investors in profound ways, a phenomenon known as herd behavior. Studies show that individuals are more likely to participate in the stock market when a higher fraction of their local community are investors. This holds true not only for individual investors but also for professional analysts.

Media Influence on Financial Decisions

Media plays a pivotal role in reinforcing herd behavior. Local media coverage of S&P 500 companies predicts local trading of those stocks, indicating attention bias and herd behavior. Stock recommendations on popular TV stock shows can generate abnormal overnight returns, showcasing the significant influence of media and popular opinion on investment decisions.

Moreover, counterfactual comparisons, involving comparing actual outcomes to what could have happened but did not, are subject to social influence. For example, recent coverage of a hot stock may prompt readers to berate themselves for not investing in the stock years ago - under the mistaken belief that their information, preferences and cash resources would have been the same then as now. Such comparisons can lead to post-decisional regret, further complicating the decision-making process.

These findings underscore the importance of recognizing and mitigating the effects of herd behavior in financial decision-making. Financial advisors play a crucial role in helping clients navigate these biases by encouraging independent analysis and decision-making based on individual financial goals, rather than following the crowd. This is particularly important in volatile markets like cryptocurrency or other investment fads.

There are parallels to be drawn from the legal sector, where a majority of lawyers express a desire for innovation within their industry. However, this aspiration is tempered by the prevailing perception that the legal field is resistant to change, resulting in the persistence of outdated practices - “Even when lawyers know what they must do, they remain, collectively, unwilling to do it.”?

Strategies for Financial Advisors

1?? Educate Clients on the Risks of Following the Crowd

Historical examples, such as the dotcom bubble, illustrate the potential negative outcomes of herding behavior. In the case of cryptocurrency, highlight recent cases, court battles, and celebrity involvement to caution your clients about the risks.

2?? Promote Independent Research and Analysis

Encourage clients to conduct thorough research before making investment decisions. For cryptocurrency, delve into the technology, market adoption, regulatory environment, and potential use cases. Remind your clients of the evolving regulatory landscape in the crypto space.

3?? Segregate "Play" Money

Mitigate risks associated with herding behavior by advocating for diversified portfolios. To those clients determined to invest in crypto, for example, recommend a balanced allocation to traditional investments like stocks, bonds, and real estate, with a small “play money” portfolio for crypto speculation.

As financial advisors, we have the power to help our clients break free from the illusion of social proof. By fostering independent thinking and promoting personalized investment strategies, we can guide our clients towards financial success. After all, as the Fleetwood Mac song says: “You can go your own way”. In the world of finance, the path to success often lies in breaking free from the noise of the crowd and charting your own course.

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