Personal biases about money and risk can have devastating effects on a person’s finances, according to Morningstar Behavioral Research.
Everyone has biases, but if they are recognized they can be dealt with and the negative effects can be mitigated, Morningstar said in a report released yesterday.
Advisors who can use the knowledge of biases can incorporate behavioral coaching into their practices to avoid the worst consequences for their clients, the research company added.
“Biases matter. By testing clients for biases, advisors can help visualize their impact and thus acknowledge the ways in which biased decisions can hurt financial outcomes,” the report said. “Segmenting people on their risk of bias can help advisors understand who needs the most help. They [can then] undertake various de-biasing techniques to mitigate their client’s biases.”
Financial and risk biases “can do real harm,” Morningstar said. “We have found ways in which high bias scores can affect credit scores, net worth, saving and spending habits. It is always possible that biases also impact the broader way in which we think about and judge the world around us. We must recognize biases for what they are and take active steps to avoid them in our financial lives.”
The study looked predominantly at four biases that affect financial health: “present bias,” which overvalues smaller rewards in the present at the expense of long-term goals; “base rate bias,” which is the tendency to judge the likelihood of a situation by considering the new, readily available information about an event while ignoring the underlying probability of that event happening; “overconfidence,” which overweights a person’s abilities to make investment decisions; and “loss aversion,” which is the tendency to be excessively fearful of experiencing losses relative to gains.
“In the last few years, the market has seen a huge influx of new, often unexperienced, investors on low-cost or zero-cost fintech platforms, which sometimes offer investing experiences designed to appeal to our biases. For example, research shows that overconfidence bias is tied to overtrading. In the past, trading fees acted as a deterrent for overconfident people to act on their bias,” Morningstar said.
There are actions that can be taken by advisors and their clients to mitigate the effect of biases on financial decision making, Morningstar said.
Morningstar advised investors to “slow down the decision-making process by setting up decision-making ‘speed bumps,’ that can help people avoid impulsive decisions while they take a step back from emotions. For example, work to create a three-day wait rule, where you can’t act on a decision for three days, or decide that a loved one or spouse must sign off on any decision before you act.”
Also, investors should set objective trading rules that never change. “For example, if a stock rises above a certain level, set a trailing stop that will lock in gains. Consider working with a fee-only advisor to formulate a written investment policy statement. This can prevent you from making irrational decisions during times of economic stress or euphoria.”
Daily events, even global ones, usually should be ignored. “Make the effort to ignore irrelevant information, particularly short-term price movements. Keep your eye on the bigger picture, and seek out information that lends itself to making that bigger picture clearer,” Morningstar said.