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Investor Behavior: Cognitive vs. Emotional Biases

Distinguishing between clients' faulty cognitive reasoning and errors based on feelings or emotions can help advisors better identify and account for behavioral investor types.

Michael M. Pompian, 03/21/2013

This month's article is the third in a series called "Building Better Client Relationships by Understanding Investor Types." This series is intended to help advisors create great working relationships with their clients by taking a step back and understanding the type of person they are dealing with (from a financial perspective).

Individuals are different in the way they process information, vary in the way they behave when faced with a financial decision, and have different risk preferences, so it is essential that advisors interact with each client effectively. This often means that you must change the way you speak to different types of clients even though your advice may be similar across your client base. Some advisors fail in their tasks not because they don't have technical knowledge of the markets, understand the strategies of investment managers, or have systems that can deliver the best methods of portfolio construction, but rather because they don't understand what is truly important to the client and how to communicate and interact in a way that is meaningful and effective.

As you know by now, I have dedicated a substantial amount of time promoting the benefits of behavioral finance research and make it accessible to large numbers of financial advisors. In my latest book, "Behavioral Finance and Investor Types," my primary objective was to simplify the practical application of behavioral finance by boiling down many of the complexities involved in diagnosing and treating behavioral biases into the simple concept of investor types, which I refer to as "behavioral investor types" or BITs. BITs are defined in large measure by the biases themselves and are categorized in a way that makes intuitive sense and can be easily understood.

The Foundation of Behavioral Investor Types
In order to fully grasp the concept of behavioral investor types, it is essential that we take some time to explore my categorization of behavioral biases. The reason is that the biases are grouped in a way that will lead directly to each type. Once you understand how biases are defined and grouped, you will understand the foundation of each BIT.

Therefore, in this article and the next we will build the foundation for understanding each type to give you a better understanding of how BITS are created--with the ultimate goal of using them in practice. Today I will discuss details of the cognitive vs. emotional framework; in the next article I will introduce an updated way of categorizing biases that further refines and improves my bias classification structure.

The dictionary defines the word "bias" in a number of ways, including: a statistical sampling or testing error caused by systematically favoring some outcomes over others; a preference or an inclination, especially one that inhibits impartial judgment; an inclination or prejudice in favor of a particular viewpoint; an inclination of temperament or outlook, especially a personal and sometimes unreasoned judgment.

In the context of this article, we are considering biases that result in irrational financial decisions caused by faulty cognitive reasoning or reasoning influenced by emotions. This classification--distinguishing between biases based on faulty cognitive reasoning (cognitive errors) and those based on reasoning influenced by feelings or emotions (emotional biases)--is an important one, and one that we will return to repeatedly throughout this series. Although researchers in the field of psychology have developed many different classifications and identifying factors to categorize and better understand biases, for our purposes it is reasonable to place biases within these two categories.

Cognitive Biases
Cognitive errors stem from basic statistical, information processing, or memory errors; they may be considered the result of faulty reasoning. Emotional biases stem from impulse or intuition and may be considered to result from reasoning influenced by feelings. Behavioral biases, regardless of their source, may cause decisions to deviate from the assumed rational decisions of traditional finance. In this series, behavioral biases are classified as either cognitive errors or emotional biases. This distinction is not only simple and easily understood, but, as noted, it also provides a useful framework for understanding how behavioral investor types, introduced in subsequent articles, are created.

The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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