Cognitive biases can often lead to suboptimal decision making (Daniels 2019). The prominence of behavioural finance has caused it to be increasingly accepted as an alternative to traditional finance theory and is based on this assumption.
Behavioural finance originated in the 1970’s and has become increasingly accepted as a way to understand “the pitfalls of economic theory that can result from the assumption of rationality” (O’Dair 2018). Individuals make decisions in two ways; one as a quick, emotional response and another more slowly and rationally (Daniels 2019).
When making quick responses, an individual will be impacted by; how information is presented to them, their current circumstances, and external influences. These factors all influence an individual’s biases, which may come from what we’ve seen or heard, actions we’ve taken and how our family, community and society has behaved around us. The combination of these factors can influence client behaviour, unconsciously and consciously. These external factors will influence how a person responds to money, until these biases are explored or challenged. Not addressing such biases may be inadvertently setting a client up for failure because ultimately it may lead to actions which are contrary to what they need to do in order to achieve their objectives.
Loss aversion is one cognitive bias which describes a person’s tendency to prefer avoiding losses to acquiring equivalent gains, and may cause clients to make decisions based on fear, which leads them to react rather than respond. This occurs commonly and leads to poor investment decisions, including being invested conservatively over the long term to avoid loss. Advisers can recognise this tendency and help clients consider the big picture, which may involve supporting clients to take a step back, and educating them about the cyclical nature of markets and the inevitability that volatility will come and go.
To help clients address their biases, advisers first need to be able to identify them. Personal probing questions may enable an adviser to do this, and include questions such as the following:
- What are your greatest financial aspirations?
- What are your greatest financial frustrations right now?
- Can you tell me more about you?
Personal questions such as those above provoke dramatically different responses ranging from short, sharp and fact-based to essay-type answers. The variation can indicate how the client interacts with money and highlight their current concerns and priorities. This can signal how their biases might influence them to respond to particular situations.
Advisers may also use profiling tools to provide similar insight into client behaviour.
- Marcus Warren.