Endowment, hindsight, and representativeness bias may be coupled with a client's status quo bias.
This month's article is the 13th in a series called "Managing Behavior in a Volatile Market" and Part II of a discussion on status quo bias. This series provides data and insight into the identification of key behavioral biases and also shows how to manage client behavior and emotion in this highly volatile market environment.
A substantial part of this series will be a review and analysis of answers to behavioral questions that were completed by a diverse set of 178 individual investors in 2011. The investors polled were not subscribers to Morningstar.com and/or Morningstar investor newsletter publications like the last survey, but they fit a similar profile in terms of investment objective and investor description.
By way of background, the survey questions were written to identify 20 key behavioral biases that I outline in my book, Behavioral Finance and Wealth Management. The second edition of the book, with updated biases and new case studies, is now available.
As noted in earlier articles, the intent of the survey was twofold. First, I wanted to identify the most prevalent biases ("Primary Biases"), so advisors would know what to look for when working with their clients. Second, I wanted to identify what secondary behaviors ("Secondary Biases") might also be lurking behind these primary biases. In other words, if client Smith has easily recognizable bias X, what other of the 19 biases might client Smith also be subject to?
The purpose in doing this is that advisors can hopefully recognize not only primary biases, but secondary biases as well. Often it is the unrecognizable biases that can cause substantial harm when attempting to keep clients on track to attaining financial goals. Advisors can hopefully gain significant insight into a range of a client's behavioral tendencies simply by being aware of a single common bias.
In order to rank as a primary bias, 50% or more of respondents need to answer at least "Agree" or "Strongly Agree" to a question designed to identify a certain bias.
There were seven biases that garnered at least 50% positive responses:
Loss Aversion Bias: The pain of losses is greater than the pleasure of gains
Anchoring Bias: Getting "anchored" to a price point when making an investment decision
Hindsight Bias: Believing that investment outcomes should have been able to be predicted
Recency Bias: Taking investment action based on the most recent data or trend rather than putting current situations into historical perspective
Representativeness Bias: Making current investment decisions using the results of past similar investments as a frame of reference
Status Quo Bias: Not taking action to change one's investment portfolio (i.e., doing nothing when prompted to do so)
Regret: Past (poor) decisions affect future investment decisions
When you are providing advice to clients, at a minimum you should be looking out for these seven biases, as they are likely to be the most commonly encountered. For example, let's say you identify that a client is loss averse. What are the other irrational biases they might be subject to? This series is intended to help answer this question for the seven biases listed above and provide tips on overcoming them.
In this article we will review the biases associated with status quo bias. Fifty-six percent of 178 people responded that they agreed or strongly agreed to a question asking them if they were subject to status quo bias (i.e., the idea that some investors don't take action on their investment portfolio when prompted to do so). Of that group, at least half of those people were also subject to the following six biases:
1. Regret (63%)
2. Anchoring (62%)
3. Loss Aversion (61%)
4. Endowment (61%)
5. Hindsight (57%)
6. Representativeness (55%)
For example, of the respondents who said they were subject to status quo bias, 63% of them were also subject to a question designed to identify regret bias, and so on for the other five biases.
Below, I will provide commentary on the second three of these biases: endowment, hindsight, and representativeness. I will discuss why these biases are likely linked with status quo bias and what you can do to counsel a client who has these biases.
Status Quo and Endowment
Status quo and endowment are very closely related. As we know, investors subject to status quo don't take action on their investment portfolioshen prompted to do so. Those influenced by endowment bias similarly hold investments they already own simply because they already own them--irrespective of why the investment was made in the first place.
An example of this bias is a 50-year-old investor still holding a bank stock that his grandfather gave him when he was 10 years old. Is it still a good investment?
The major implication for status quo and endowment is that these biases often keep otherwise good-intentioned investors from taking proper action on their portfolios when called upon to do so. Some investors freeze up when it's possibly a great time to invest (e.g., market dislocations).
Advice: Investors subject to status quo and endowment should recognize that not taking action is, in effect, taking action not to do something. Holding investments that one has an emotional attachment to is a recipe for future losses. Whenever possible, try to take a step back and evaluate each and every investment on its merits. And it is very important to do this in the context of a structured investment decision-making process, as I have noted many times in past articles.
Status Quo and Hindsight
Status quo and hindsight are connected, although this may require some explanation. Some investors are generally more comfortable keeping things the same rather than making changes to their portfolios, and therefore they do not necessarily look for opportunities where change is beneficial. Given no apparent problem requiring a decision, the status quo is maintained. Similarly, hindsight causes investors to avoid looking unwise whenever possible. They may avoid making a decision (taking action) because they do not want to make the wrong choice.
Advice: Getting investors who do not wish to take action "off the dime" to make decisions is not easy. As I have said before, and I will repeat it because it's crucial to understand: Demonstrating through quantitative analysis is not always effective. What I recommend is to take action in smaller increments. For example, if the objective is to get invested, then clients can "average in" to the markets--taking three months or six months. This often puts the fear of losses aside; if an investment goes down, you can buy more at lower prices.
Status Quo and Representativeness
Status quo and representativeness bias are connected, but it may not be obvious why. As noted, when people are subject to status quo, they don't embrace change easily. Investors with representativeness bias use prior experience as a frame of reference for current decisions. Putting the two ideas together, some investors are more comfortable with seeing an investment opportunity through their own preferred historical lens, which may involve not making changes (i.e., they are more comfortable keeping things the same than with change, and thus do not necessarily look for opportunities where change is beneficial). For example, a client may think about a past investment in which they lost money--if only they had done nothing! But mistakes will happen! The process is what is important.
Advice: Creating and using investment policy statements and rebalancing rules are key to taking emotion out of the investment decision-making process. Whenever possible, try to train your clients to think in terms of regular rebalancing--as opposed to ad-hoc decision-making. It will make a huge difference and help make your client relationships much better!
Hopefully you have learned something about status quo and the biases connected with it. When you encounter a client with status quo bias, think about the examples you have read about in this article. It might help to build a better client relationship! In next month's article, we will review the first three biases associated with regret.