Leveraging behavioral finance

We are living in unusual times. The coronavirus pandemic has affected all aspects of the global economy, putting the spotlight on behavioral finance and investing.

Behavioral finance, a part of behavioral economics, is a field of study that explores the effects of psychological, cognitive, emotional, cultural and social factors on the decision-making process of individuals and institutions. Behavioral finance suggests that psychological influences and biases affect the financial behaviors of investors and financial practitioners.

Although volatility has always been a part of the global markets cycle, the pandemic has inevitably created a heightened period of volatility this year, as investors scramble to stabilize their portfolios and limit their losses. A recent white paper by Charles Schwab Investment Management and Cerulli Associates suggests that advisors must do more to incorporate behavioral finance into their practice to help mitigate biases.

Though awareness of behavioral finance is becoming more widespread, advisors are more likely to incorporate its principles into their everyday communication with clients rather than within the context of their portfolio construction processes.

The whitepaper which findings originate from a 2019 survey conducted with more than 300 financial advisors found that the most common behavioral biases impacting clients are: recency bias, loss aversion, and confirmation bias, while advisors rank loss aversion and overconfidence as the most prevalent biases impacting their own investment decisions.

Advisors cite strengthening trust with clients, improving investment decisions, and better managing client expectations as the greatest benefits of incorporating behavioral finance into their practice.

While advisors recognize the value of behavioral finance, many find it challenging to apply concepts in everyday practice. Advisors cite difficulty translating theory into implementation, and a lack of software/tools as the primary reasons preventing adoption.

According to the whitepaper, both advisors and clients are prone to behavioral biases that can impact their investment decisions. By gaining a stronger understanding of these biases and recognizing when they are most likely to impact one’s own investment decisions, advisors can minimize regretful decision making.

Cerulli outlined five best practices that can help advisors more effectively apply behavioral finance tactics in their practices. The first is to construct goal-based strategic portfolios, as clients are more likely to stay on track with a diversified investment plan that connects to their specific goals over the long term. Automation in this aspect can also be achieved with AI and machine learning technology for robo advisor platform.

The second practice is to create automatic/systematic processes to take emotions out of investment decision-making by automating the process – for example automatic rebalancing. This can be achieved with the use of cutting-edge technology and software that can efficiently react to real-time data to rebalance portfolios accordingly.

The third is investment in education as it is a critical element to help clients understand their biases and, with the help of the advisor, provide structured support and guidance. Fourth is to proactively communicate with clients about their biases and identify clients who are prone to certain biases – for example, loss aversion and recency bias – and discuss emotional tendencies before they occur. And last is to be mindful of internal biases, as advisors need to be aware of their own biases – such as overconfidence – to improve the investment decisions made on behalf of clients.

The most important thing is to remember why an investment is made in the first place. More often than not, when times are good, investors tend to focus on the positives and, when times are bad, they gravitate towards the negatives. It is crucial to bear in mind that it is not about eliminating investments with obligations, but it is about understanding a portfolio and aiming to be balanced about it.