What inspired you to write this book?
The objective of this project was to develop the first comprehensive behavioral finance book that integrates the financial planning process and investment management based on the emerging research findings. The vast amount of the content in the book focuses on the decision-making process of the individual decision maker. This micro-behavioral finance viewpoint provides the reader with extensive new research for understanding their mental mistakes and methods for improving the decision-making process of individual investors, financial advisers and traders.
How does the book help financial advisers?
Financial advisers will learn about an extensive collection of psychological biases that their clients suffer from in this book. The material in the book provides various strategies for assisting clients in overcoming these biases and improves their overall financial decision making.
For example, a major finding from the book for me was the two unique polar opposites of traders versus investors. Traders tend to trade too much because they are overconfident and this reduces their profits at times. Investors in retirement accounts demonstrate the opposite behavior. Retirement savers tend to be “status quo” investors who suffer from inertia and a lack of activity that can have a negative impact on an individual’s risk tolerance and asset allocation strategy. An important lesson is to understand the specific mental mistakes and emotional issues that they suffer from and then develop a disciplined strategy. A major lesson is to have a balance between an active and a passive strategy in which an investor rebalances his/her portfolio on a yearly basis.
How can financial advisors deal with client biases like risk aversion, negative emotions and irrationality?
Many clients exhibit negative emotions such as worry, depression and fear. For instance, worry fosters past memories and visions of future events that alter short-term and long-term judgments about financial decisions. A study conducted by me in 2011 found that a large majority of individuals investors associate the term “worry” with common stocks (for 70% of the research sample) over bonds (for 10% of the research sample). A higher degree of worry for an investment such as a stock increases its perceived risk, lowers the degree of risk tolerance among investors and increases the likelihood of not investing in the stock. To avoid this bias, financial advisers should match a client’s level of risk tolerance with a pre-determined asset allocation strategy. Advisers should administer a simple experiment by communicating to clients that if they lose sleep because of a high degree of worry about their common stocks, they should own more conservative investments and thus hold a less risky portfolio of securities.
Many investors enter when the market goes up and exit when the market falls. How do you explain this behavior?
Many investors suffer from anchoring bias that has a detrimental influence on all categories of investors. The anchoring bias is our strong preference where we all have to latch on to a viewpoint that may or may not be true and use it as a reference point for future decisions. For example, if an investor lost money on a technology stock in the past; the anchoring bias might prevent the investor from consider investing in a technology stock in the future. In other words, the investor purchased the stock at a high price and sold it a lower price resulting in a severe loss. This monetary loss is also an “emotional loss” for most investors. Unfortunately, even when a person realizes he or she is suffering from the anchoring bias it is difficult for them to leave the “anchor” if the past decision was emotionally traumatic.
Herd mentality is a very common among investors. How can advisers help them get rid of such fallacies?
A major cause of herd mentality is that investors are influenced by risk-taking behavior, anchoring, and crowd psychology. An essential aspect of the investment decision making process is to understand an individual’s level of risk tolerance and risk perception. Risk tolerance is the degree of risk that a client is willing to accept when pursuing a financial goal or the maximum amount of loss a person is willing to experience when making a financial choice. Risk perception incorporates different objectives and subjective issues that influence how people make judgments about financial products and services. Anchoring is the inclination of individuals to have a belief and then apply it as a reference point for making future decisions. Clients often base their decision on the first piece of information to which they are exposed such as the initial purchase price of a stock and thus find changing their judgment to new information extremely difficult. During a bubble situation, the herding behavior of the group increases a person’s risk tolerance and decreases their risk perception of stocks. Individual investors start to believe stock prices will increase for unrealistic time periods based on this anchoring effect and continue to follow the herd until the bubble bursts.
To avoid this situation, financial advisers can assist clients by assessing their degree of risk tolerance and emotional reactions of perceived risk for a wide range of financial securities. Advisers should communicate to clients the importance of not focusing their investment decisions on a specific reference point of information, holding a diversified investment portfolio and avoid the detrimental aspects of group behavior.
What is a common bias among individual clients? How can financial advisers assist their clients in overcoming this bias?
Individuals often lack self-control and prefer spending money today rather than investing for the future, such as saving for retirement with an annuity. If an annuity is described in the context of an equal amount of money in retirement age, such as $1,800 per month, clients are less likely to make the investment decision. To overcome this behavior, individuals should “reframe” the financial situation. In this context, the issue of framing is how the financial product or service is presented to a person based on the correct word association. For instance, an individual could frame the annuity decision as a resource of funds that can be spent in retirement age such as $1,800 per month for purchasing a new car. When the financial goal is linked to a spending activity, this dramatically increases the likelihood that the individual will invest in the annuity and then reach their financial objective in the future.
Victor Ricciardi is a Finance Professor at Goucher College in Baltimore, Maryland and co-editor of the book Investor Behavior: The Psychology of Financial Planning and Investing with Kent Baker.
