People at times make decisions under the influence of certain emotions or irrational assumptions. As a guide, philosopher and friend to their clients, MFDs must comprehend the hidden messages in investor behaviour. Decoding clients’ mind-set helps in identifying their biases which can then be dealt with skilfully.
The latest episode of Lessons from the Masters was dedicated to decoding investor psychology. Dr Kavitha Ranganathan, Associate Professor, Finance & Strategy at TAPMI and Amit Trivedi, renowned author and trainer shared tips on how to manage investor behaviour. K S Rao, Head - Investor Education & Distribution Development, Aditya Birla Sun Life MF, moderated the discussion.
Here is how MFDs can identify and deal with investor biases.
Emotions and human behaviour go hand in hand
Emotions always exist, what is important is to understand which emotions are helpful and which ones are to be kept at bay. There exist two types of emotions - integral and incidental. Integral emotions are a part of decision making and also create some dilemma. For example, many people get disappointed after knowing about risk associated with their investment. On the other hand, incidental emotions have nothing to do with decision making. Frustration due to a bad day or a long wait in traffic is an incidental emotion.
The expert bull and the wise bear
Overconfidence and loss aversion are the two major biases to be mindful of while dealing with clients. A new investor booking profit in a market rally may like to take credit for it and this could result in him/her being overconfident. On the other hand, the fear of making losses may compel an investor to make an early exit. As Amit says in his book ‘The Roller Coaster: Lessons from financial market cycles we repeatedly forget’, “In a bull market, everyone becomes an expert! In a bear market, everyone becomes wise!” MFDs must take the onus to regularly educate their clients about how the markets work to prevent them from developing biases.
The need for statistical literacy
Professional investors are generally able to assess risk better than common investors. MFDs must impart statistical literacy amongst their clients. Explaining concepts like standard deviation, dispersion, mean return, etc. can aid retail investors to have a better understanding of risk. Further, walking the clients through the fund selection methodology also helps in removing some of the biases. It is recommended to group goals in different buckets like safety/survival, midlife goals, legacy creation goals and philanthropic goals. Thereafter, MFDs may create a portfolio and address the associated risks for each bucket.
Moderate cognitive biases and adapt emotional biases
Cognitive biases stem from the inability to understand information or statistics. For example, an investor is said to be biased where he/she anchors on a particular parameter, which may not be salient to decision making. MFDs must moderate cognitive biases by imparting financial literacy. On the other hand, emotional biases are a result of feelings. Loss aversion is one such bias, where it is advisable to adapt it rather than push the investor to take risk. Further, MFDs must use choice architecture to nudge their clients to make the right decision without taking away their freedom to choose.
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