While humans often consider themselves superior to other beings on Earth, this status in the animal kingdom has its drawbacks. Our capacity for complex thought also means we are uniquely skilled at self-deception and harboring irrational thoughts, more so than any other species on the planet.

The resulting quirks we possess as a species have been categorized into a wide array of cognitive biases. Many who study human behavior are familiar with this graphic, depicting 188 different biases that people fall prey to all the time. Though many of these are worth understanding in more depth, most can be consolidated into four main categories within the cognitive bias universe: ego, emotion, attention and conservatism.  

For advisors, understanding these four areas of human tendencies can greatly aid in understanding the underlying psychology driving their client’s behaviors. This is especially true of the less logical and instinct-driven actions a client might wish to take when it comes to managing their portfolio.

To help advisors better understand their clients, let’s unpack these spheres of human instinct and how advisors might utilize this knowledge to guide better client outcomes.

This encompasses the various types of overconfidence to which all human beings are susceptible. There are three distinct forms of this phenomenon. Firstly, we all tend to believe we are above average, which is mathematically impossible. Secondly, we often think we are luckier than average, underestimating the likelihood of adverse outcomes and overestimating the chances of positive events. In other words, we don’t think we will get divorced—even though 42% of people between ages 45 and 54 have experienced this—yet we do believe we will win the lottery, despite the overwhelming odds against it. Thirdly, we assume that we are more prescient about the future than we really are, which can lead us to take excessive risk. In a financial context, this might present as a belief that we can time the market, thus undermining the need for a professional advisor.

When we overestimate our abilities, luck and capacity for future foresight, it’s easy to see how this may lead to some poor financial decision making.

Now what? Advisors can help their clients overcome this set of biases by leveraging historical data and relevant studies. This evidence-based approach can illustrate the real impact of certain investing decisions versus what the client believes to be true. For instance, advisors might shed light on the fact that single stock ownership has traditionally been a high-risk approach, with only around 20% of stocks managing to survive and surpass market performance over two decades. This underscores the case for diversification, which has the potential to mitigate outsize losses resulting from ego-based risk.  

Explaining the proven need for diversification is a great place to start, as the science that underscores the need for this in portfolio construction is humbling by nature. Investors cannot predict market movements, but they can potentially offset market fluctuations by spreading their investments across various asset types, thereby accumulating wealth.

The emotion category captures biases that reflect our broad tendency to blur the lines between feelings and logic during the financial decision-making process. This notion was advanced via pioneering research from psychologists Daniel Kahneman and Amos Tversky, which revealed that during financial decisions, individuals often lean on heuristics and biases influenced by emotional and psychological factors, rather than engaging in purely rational analysis.

Building on this understanding, the affect heuristic further illustrates how an individual’s current emotional state can color their perception of the world at any given moment. For example, when asked to describe their childhood, someone who’s having a bad day might predominantly recall instances of bullying and social exclusion. Conversely, when in a good mood, the same person might reminisce about joyful times at the beach or enjoying ice cream with friends. Thus, our mood-based perceptions shape our reality.

Now what? The first step is becoming aware of emotions and their power to influence behavior. Advisors cannot rid themselves or their clients of emotion, but they can utilize their understanding of these emotion-driven biases to their benefit.

An example can be found in the Nobel Prize-winning work of Richard Thaler, who made the groundbreaking discovery that humans tend to divide their money into different accounts and then save or spend differently based upon the labels assigned to those accounts. This phenomenon explains why individuals are more inclined to save when they designate savings accounts for specific purposes, such as “travel” or “new house”—because these goals bear sentimental meaning. Such insight offers a prime opportunity for advisors to apply their understanding of emotional influences, motivating clients to save for future goals like retirement or to embrace greater risk in certain investment scenarios.

It’s not about eliminating emotions; it’s about affording clients an understanding of how their emotions could be shaping their worldview, then developing strategies that acknowledge and address these emotional influences.

This area of biases describes the tendency to confuse things that are loud with things that are likely. It can seem that every year, the media rings the alarm bell about an impending recession. Yet, an examination of the data reveals there have only been 14 recessions in the United States since The Great Depression in the 1930s. Similarly, the probability of experiencing a shark attack is minuscule, at one in 3.7 million, while the chance of developing coronary artery disease (CAD) in adults over 20 is far greater, at one in 20. However, fear of a shark attack generally eclipses the much more likely outcome of heart disease. They made the movie Jaws about sharks for a reason—fear sells.

Now what? With this insight, advisors can empower their clients to be critical consumers of the media. Financial advisors have a vital role in illustrating to investors that their primary aim is to secure the client and their family's financial well-being. This approach can be markedly different from that of certain media personalities, who may primarily pursue their own financial gain. Encourage clients to explore the underlying incentives, and they will quickly find out who has their best interests at heart.  

It’s also important to remember that environment is a much better predictor of behavior than goals. As author James Clear advises, “you do not rise to the level of your goals, you fall to the level of your systems.” The same might be said of media consumption. Even if the client strives for optimism regarding their financial plan, a diet of negative financial news and social media doomscrolling stands to throw them off course. By helping clients to build and sustain good habits around media consumption, advisors can support those they serve in navigating this category of biases.

The last bucket of biases encompasses our distaste for uncertainty and the unfamiliar. Kahneman received the Nobel prize for his work on prospect theory, which found (among other things) that people are two and a half times more upset about a loss than they are happy about a comparably sized gain. In other words, if they win a hundred dollars, they are moderately happy, but if they lose a hundred dollars, they are outright furious.

From an evolutionary standpoint, conservatism is quite logical. In the times of hunter-gatherers, all it took to be wiped off the earth for good was one bad day. Therefore, it's understandable that humans are inherently cautious. However, this aversion to loss can be detrimental in investing and financial planning, where avoiding potential risks may lead to missed opportunities. This might manifest as excess cash holdings, inadequate diversification, and so forth.  

Now what? Knowing that clients have an innate desire to pursue the safe and familiar, advisors can combat this by steering them away from money management decisions rooted in fear and scarcity-based thinking. An investor may be concerned if they see the short-term losses associated with holding a particular stock, but the advisor can zoom out and highlight the elevated returns associated with longer-term investments. Once again, it involves educating clients about their deeply ingrained behaviors, while offering concrete evidence to support an alternative path forward.  

Armed with an understanding of these four key areas of bias, financial advisors can act accordingly to help clients overcome unproductive or misguided belief systems. Understanding oneself as an individual is the first step in understanding oneself as an investor, a concept that holds true for advisors looking to gain better insight into their clients' needs.

The ability to guide clients is directly linked to advisors' readiness to confront and learn from their own biases. By educating clients about how these biases might influence their financial decisions and reflecting on these principles in their own investment practices, advisors can foster a culture of mutual growth and understanding — illustrating that overcoming these biases is a shared journey.

Dr. Daniel Crosby is chief behavioral officer at Orion Advisor Solutions.