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A Closer Look at Investors' Cognitive Biases

By further categorizing cognitive biases into belief perseverance and information processing, advisors can better understand their clients' behavior and help them make better decisions.

Michael M. Pompian, 04/18/2013

This month's article is the fourth 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 making 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 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.

In this article we will continue building 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 refine the cognitive vs. emotional framework, which will help you to deal with the cognitive biases of clients. In the next article, I will introduce the behavioral investor type framework.

In the last article, we defined cognitive and emotional 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 result from reasoning influenced by feelings. Behavioral biases, regardless of their source, cause deviation from the assumed rational decisions of traditional finance. As I have discussed on many occasions, emotional biases are difficult to correct, and a "counseling" approach is much more effective.

On the other hand, I often receive questions on how to best handle cognitive biases. So, to further help advisors deal with the complexities involved with cognitive biases, I have created two sub-categories: "belief perseverance" biases and "information processing" biases.

Belief perseverance, in the context of behavioral biases, is the tendency to cling to one's previously held or recently established beliefs irrationally or illogically. Investors continue to hold and justify the belief because of their bias toward belief in themselves or their own ideals or abilities.

Information processing biases, as you might expect, are cognitive errors that have to do with how people process information either illogically or irrationally in financial decision-making. In the next two sections, I will identify and categorize 13 cognitive biases. After that, I will give advice for dealing with cognitive biases in practice.

Belief Perseverance Biases
The belief perseverance biases are: conservatism, confirmation, representativeness, illusion of control, hindsight, and cognitive dissonance. I will briefly define each of these biases so you can see how these are categorized as such.

Conservatism bias occurs when people maintain their prior views or forecasts by inadequately incorporating new information that arises. They pursue their own beliefs rather than incorporating factual data.

Confirmation bias occurs when people tend to look for and notice what confirms their beliefs and to ignore or undervalue what contradicts their beliefs.

Representativeness bias occurs when people classify new information based on past experiences and classifications. They believe their classifications are appropriate and place undue weight on them. This bias occurs when people who are attempting to derive meaning from their experiences classify objects and thoughts into personalized categories.

Illusion of control bias occurs when people tend to believe that they can control or influence outcomes when, in fact, they cannot.

Hindsight bias occurs when people see past events as having been predictable and reasonable to expect. People tend to remember their own predictions of the future as being more accurate than they actually were because they are biased by the knowledge of what has actually happened.

Cognitive dissonance bias occurs when newly acquired information conflicts with pre-existing understanding, and people experience mental discomfort. Cognitions, in psychology, represent attitudes, emotions, beliefs, or values; cognitive dissonance is a state of imbalance that occurs when contradictory cognitions intersect.

As you can see, the common thread that runs through these biases is that, in each of them, people's beliefs are irrationally pursued.

Information Processing Biases
The second category of cognitive biases is information processing. They result in information being processed and used illogically or irrationally, as opposed to the act of clinging irrationally to one's own beliefs. The processing errors we will discuss are: anchoring, mental accounting, framing, availability, self-attribution, outcome, and recency.

Anchoring is an information-processing bias in which the use of psychological heuristics influences the way people estimate probabilities. When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial default number--an "anchor"--which they then adjust up or down to reflect subsequent information and analysis.

Mental accounting bias is an information processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to. This method contradicts rational economic thought because money is inherently fungible. Mental accounts are based on such arbitrary classifications as the source of the money (e.g., salary, bonus, inheritance, gambling) or the planned use of the money (e.g., leisure, necessities).

Framing bias is an information processing bias in which a person reacts to a situation differently based on the way in which it is presented (or framed). The frame that a decision-maker adopts is controlled partly by the formulation of the problem and partly by the norms, habits, and personal characteristics of the decision-maker.

Availability bias is an information processing bias in which people take a heuristic (a rule of thumb or a mental shortcut) approach to estimating the probability of an outcome based on how easily the outcome comes to mind. Easily recalled outcomes are often perceived as being more likely than those that are harder to recall or understand.

Self-attribution bias refers to the tendency of individuals to ascribe their successes to innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck.

Outcome bias refers to the tendency of individuals to decide to do something--such as make an investment in a mutual fund--based on the outcome of past events (such as returns over the past five years) rather than by observing the process by which the outcome came about (the investment process used by the mutual fund manager over the past five years).

Recency bias is a cognitive predisposition that causes people to more prominently recall and emphasize recent events and observations than those that occurred in the near or distant past.

Each of these biases involves people processing information irrationally.

Dealing With Cognitive Biases
In my experience, cognitive errors are more easily corrected than emotional biases. Individuals are better able to adapt their behaviors or modify their processes if the source of the bias is logically identifiable, even if the investor does not fully understand the specific investment issues under consideration.

For instance, an individual may not understand the complex mathematical process involved in updating probabilities when presented with an everyday financial decision but may comprehend that the process he or she used before was not complete or correct.

Cognitive errors can also be thought of as blind spots or distortions in the human mind. Cognitive errors do not result from emotional or other predispositions toward certain judgments, but rather from either subconscious mental procedures for processing information or irrational perseverance in one's own beliefs. Because cognitive errors stem from faulty reasoning, better information, education, and advice can often correct for them.

By further categorizing cognitive biases into belief perseverance and information processing, advisors can better understand their clients' behavior and help them make better decisions.

Hopefully you have gained a better understanding of cognitive biases and how to deal with your clients' irrational behaviors. In next month's article I will introduce the behavioral investor type framework.  

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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