Loss Aversion
Loss aversion is also related to the frequency in which clients and investors encounter financial information, said Wendel.
“Loss aversion is the undue focus on loss versus gain,” said Wendel. “Frequent information brings up myopic loss aversion, related to time, where losses loom larger than gains. People become much more conservative and more risk intolerant. Some are simply risk intolerant in general and we need to work with them where they are, but we find that risk tolerance changes with the market.”
Wendel said that recent research has uncovered that a person’s risk tolerance, which informs their loss aversion, depends most on recent market performance. One way to tackle loss aversion is to have clients pre-commit to an allocation, investing style or set of rules.
Wendel brought up an example from Homer’s “Odyssey,” in which Odysseus and his crew are approaching the sirens, deadly creatures who lured sailors with their song, tempting them to jump overboard and drown. Odysseus had his shipmates tie him to his ship’s mast so he could hear the sirens’ song, but not react—and then had his own men plug their ears with wax so they could not be tempted by the song at all.
“Knowing you’re going to be tempted in the future, you close off your options so it’s difficult to be tempted into bad behavior,” said Wendel. “Pre-committing by writing a detailed investment policy statement that goes through allocation, reasons for investing, and what you plan to do in the face of losses to handle the situation. This statement can also bring in the values of the person, what they really care about, so there’s something deeper and more fundamental that’s not changing.”
Confirmation
“Confirmation bias is the tendency to seek out and pay more attention to information that already supports our opinions,” said Lamas. “This bias is especially terrible and hard to overcome because it can happen when advisors try to do our due diligence, research, and look at extra sources. Our minds are just more comfortable following and understanding information that already supports our ideas. This can be especially important when it comes to our finances.”
To combat confirmation bias, advisors can first explain the reasons why a client shouldn’t favor information that supports their opinions, said Lamas, but a more effective technique may be to ask clients to build counterarguments to their own beliefs by researching contrary opinions.
Action Bias
Action bias explains why most investors follow the axiom “don’t just stand there, do something” instead of the famous variation on that axiom from Vanguard founder Jack Bogle: “Don’t do something, just stand there.”
It feels unnatural to do nothing in the face of craziness in the markets, or in the world at large, said Wendel. A good example of action bias comes from the world of soccer, where during penalty kicks, soccer goalies are instinctively more likely to jump to one side or the other to prevent a goal, when their best course of action, statistically speaking, is to remain in the middle of the goal.
“Agree beforehand with clients to set a cool-down period on investment deisions,” said Wendell. “Maybe take three days so the person can calm down. Even if the market is still crazy, cooling down tends to bring out their better angels. Give someone a chance to rethink their course of action.”
Advisors can also use a bucketing technique to connect a client’s assets to specific goals or purposes, said Wendel, including one bucket, preferably small, where it’s OK to take action when financial markets are volatile.
Herd Following
Sometimes, clients say things to their advisors like “everyone is going all-in” on a stock or an area of the market, or that “all of the market” is crashing.
“’Everyone else is doing this,’ or ‘all of the market is...’—those are signs of herding behavior,” said Wendel.
When encountering such behavior, advisors should encourage clients to think about their reference groups. Does the end investor really want to follow the crowd, or do they want to identify individuals that they consider superlative to the herd, like maybe Berkshire Hathaway Chairman Warren Buffett, or the community of “Bogleheads” that follows the simple, efficient investment precepts of Jack Bogle.