The financial advisor/client relationship is evolving. Traditionally, many financial advisors would help their clients pick stocks or mutual funds and speak with them once a year to discuss performance.
As asset management becomes more commoditized the process of just picking investments has become the bare minimum of what an adviser should be doing. I believe it has become less important than the multitude of other financial factors people face on a daily basis.
A sound investment philosophy is important, however, increasingly important is your behavior.
Behavioral Finance is a field of study that combines psychological theory with finance and economics. It aims to understand why investors act the way they do. Behavioral finance shows that investor’s choices can often be explained by behavioral biases, or traps, that can sometimes lead to bad decisions.
As author and NY Times columnist Carl Richards says, “An advisor’s job is to look you in the eye, shake their head, and walk you back from the ledge”.
Below are three behavioral biases with tips on how to combat each of them:
Hometown Bias
If you live in the Southern Tier of NY, odds are you own shares of Corning Inc. (GLW).
I have worked with numerous locals, who were both Corning employees and non-employees. Unfortunately, some are biased in thinking Corning’s stock is consistently “headed higher”. The truth is that, Corning is a very good company but historically a poorly performing stock. It is very difficult to separate these two.
TIP: Don’t hold more than 10% of your investments in any one stock, even if it drives the economy of your hometown.
Choice Paralysis
I see this every time I take my kids to redeem a gift card at Toy’s R Us. My children are completely overwhelmed when faced with choosing between Pokemon, Shopkins, Legos, and the thousands of other toys on display.
I see similar behavior when it comes to clients picking mutual funds in their retirement account. I ask clients why they chose a particular fund. Most of the time, having choices is a good thing. However, an abundance of choices can lead to an information overload. People end up picking random funds with no real strategy behind their choice.
TIP: Have an investment strategy! Do your research and know what you are looking for so choosing the appropriate funds is less overwhelming.
Herding or Trend Chasing
You see the disclaimer everywhere in the investment world, “Past performance is not an indicator of future returns” yet you see performance track records heavily marketed as the main reason to pick a fund.
We have an extraordinary talent for recognizing patterns and when we find them, we believe in their validity. When we find a pattern, we act on it but often that pattern is already “priced in”. When a stock has “priced in” information, all investors already know these facts and have already acted accordingly in making their buy and sell decisions.
What does this mean? The average investor will commonly buy high and sell low. Instead, as Jason Zweig writes, “Hold Your Nose and Buy Europe”.
Tip: If your cousin Larry is giving you a stock tip, chances are it’s way too late to jump on the bandwagon.
