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Fighting the behavior gap

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We’ve all seen investors who struggle to stay the course — whether that’s because they act rashly in a downturn, get overly excited about a market fad, or unduly focus on recent performance history. Behavioral researchers have long since identified cognitive biases like overconfidence bias and recency bias that exacerbate these problems; now we’re increasingly discovering techniques that can help investors overcome (or at least avoid) them, as well.

Here, we’ll look at some of the options available to advisers and consultants, to help investors on their path. These lessons come from a guide that I recently developed with Dr. Sarah Newcomb at Morningstar on how advisers can apply behavioral science to their work; you can find the free guide here.

Mind the gap
Let’s start with one of the most common scenarios: investors who exit during a down market. If you ask investors if they would like to buy an expensive fund and then sell it back when it’s cheap, they’ll think you’re crazy.

However, that’s exactly what happens, again and again with many investors. And, numerous research studies have shown how investors undermine their success in the process. For example, the table below shows how the average investor receives significantly lower returns than their investments officially offer, because investors enter and exit those investments at the wrong time: aka the “behavior gap.”

One promising way to attack this problem is to use a commitment device, according to an article in the Annual Review of Economics. The idea behind commitment devices is simple: in a moment of strength, binding oneself to a course of action to avoid future temptation.

An example can be found in Homer’s Odyssey, in which Odysseus had himself tied to the mast of his ship so that when he heard the alluring Sirens’ song, he wouldn’t fall to temptation and jump overboard. For the investor, one Siren’s song that leads investors to sell at exactly the wrong time is the apparent “safety” of selling and going to cash in volatile markets.

Investors, and their advisers, can use commitment devices to avoid that future temptation. The most extreme example would be to lock in invested funds, and remove the option of selling until a set period of time has elapsed. But, there are less extreme options too. Investors can ask their advisers to require that another person sign off on any sale (for individual investors, that might be their spouse), or require a waiting three--day period before a sale is executed.

Investors can also commit themselves in writing, with a letter to themselves. This type of letter is a simple promise, made when emotions are stable, to remember their chosen investment strategy and hold steady when things get bumpy. When the market takes a severe downturn, the adviser would email or hand the investor a copy of the letter as a reminder of their personal commitment.

Each of these approaches makes it more difficult for the investor to “jump ship” when the temptation to do so arises.

A range of techniques that advisers can use
Commitment devices are just one option, however, and the right tool to choose depends on the particular challenge the investor is facing. For quick reference, here’s a short summary of some of the challenges – and potential solutions.

Overconfidence Bias
What is it: Being overly optimistic about one’s likelihood of success. For example, investors often falsely believe they can select investments better than most people and can outperform the market.

How to tackle it: Educating investors about the prevalence of overconfidence appears to be effective. That doesn't mean telling an investor that she is being overconfident, but instead educating her about the fact that all investors tend to be overconfident, according to an article in the Review of Behavioural Finance

We can’t just choose not to fall prey to these cognitive biases. So simply telling investors to be smart and resist them is woefully insufficient.

Confirmation Bias
What is it: Subtly seeking out and paying more attention to information that supports one’s viewpoint. For example, believing that a particular company or sector will do well in the future, and then “finding” information online that agrees.

How to tackle it: Ask the investor to list reasons that others might give against their viewpoint. That is, to carefully think through an opposing viewpoint, according to an article in the Journal of Experimental Psychology: Human Learning and Memory. Another technique is called “prospective hindsight,” in which you ask investors to imagine a future time in which they learn that they were wrong, according to an article in Journal of Behavioral Decision Making. Then ask them to explain why that happened.

Recency Bias
What is it: Focusing unduly on recent events and using them to judge the future. For example, believing that an investment’s recent stellar performance means it will do well in the future.

How to tackle it: Show the investor vivid, powerful examples of where buying after stellar performance led to disaster, like the run-up to the 2008 bust. Statistics alone aren’t enough; the more vivid and easy to remember the example, the better. In addition, you can arm investors with an alternative way to interpret past performance with easy to remember rules. For example, “when prices go up, the opportunity to profit usually goes down” or “the danger of losing money usually goes up as prices rise.”

Present Bias
What is it: Not taking future needs seriously enough, and focusing on the present instead. For example, not putting aside enough for one’s investments to have a comfortable retirement.

How to tackle it: As an adviser, you can ask investors to list out each of their likely expenses in retirement, and prompt them for ones that are missing. For many investors, the amount they’ll need is surprising, and makes the future more real. Another technique is to try to make retirement itself more vivid and real for the individual: such as with age-progressed images of their faces, according to an article in Journal of Marketing Research. Also effective are detailed descriptions of where the investor would like to live, and so forth. In addition, you can ask clients to pre-commit to saving more when they receive their next raise or bonus.

Looking ahead
If there’s one overriding lesson in the behavioral research it’s this: we’re all hardwired for these biases, and we can’t just “choose” not to fall prey to them. Thus, the most common advice in the investment community – telling investors to be smart and resist them – is woefully insufficient. Thankfully, advisers can find clever ways to avoid or short-circuit these biases, as you’ve seen above. While there are no panaceas, hopefully these suggestions can help you discover what will work for your clients so they can stay the course and succeed at their investment goals.

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