While conventional wisdom suggests that removing emotions from investing decisions would result in better outcomes, the reality isn’t that simple. Emotions are an inherent part of human decision-making and remain constantly in play in investing – not just during periods of market volatility and economic uncertainty. Because they result in cognitive biases and impulsive decisions, emotions create ongoing challenges for investors and advisors alike.
But rather than fighting an impossible battle to eliminate emotions entirely, financial advisors can work to understand behavioral finance principles and biases to help guide clients in making more informed and rational decisions. By going beyond delivering traditional financial advice to acknowledge the underlying emotions investors feel, advisors can address the mindset barriers impacting long-term financial success.
What is behavioral finance, exactly?
Behavioral finance is the study of how psychological influences and biases impact financial behaviors of individuals and financial practitioners. Some of the most common biases affecting investment decisions include:
Herd mentality – People are social creatures, and often follow the crowd instead of making independent decisions. This can lead to investors chasing trends out of FOMO, which can contribute to poor timing and even result in market movements and bubbles or crashes.
Confirmation bias – Investors tend to seek out information that supports their views and ignore contradictory evidence, which can lead to false confidence, risky behavior, and skewed decisions based on incomplete or inaccurate information, resulting in poor outcomes.
Recency bias – Recent market events disproportionately influence investors' expectations of future events, causing panic selling in downturns or excessive buying during rallies based on short-term thinking.
Loss aversion – We’ve all been there, the losses feel more painful than the gains feel rewarding. This bias can influence investors with loss aversion to sell strategic investments prematurely to lock in gains and avoid the potential disappointment of a future decline.
Advisors have long known that people are going to want to do the wrong thing at the wrong time. By understanding cognitive biases and working with investors to counteract them, advisors can help clients avoid making fear-based decisions that could undermine their long-term goals.
Tips to address biases and keep clients on track
Since every client has biases, it’s important to incorporate behavioral coaching into your service model right now. Identifying and addressing biases can help to prevent impulsive decisions driven by market volatility, changes to tariff policies, and other events.
Here are a few tips for getting started:
- Be proactive, not reactive. Work with clients to put a plan in place before things happen to prevent investors from panicking or making costly mistakes.
- Identify biases. Do your homework during periods of market calm to prepare for volatile environments. This way, conversations can be more productive during volatile periods and you can better tailor suggestions to investors’ preferences.
- Understand clients’ goals: To help clients overcome biases, you’ll need to work closely with clients to understand their perspectives, mindset, and goals. Continually remind them of their long-term goals and the importance of staying the course, despite market fluctuations and how they feel in the moment.
- Actively listen. Successfully engaging with clients goes beyond repeating their words. Instead, reflect on what they say and ask questions.
- Empathize. Demonstrating empathy is key for investors who may be feeling overwhelmed, anxious, and emotional. Their fear is real, and acknowledging and leaning into their emotions can help make it easier to work through plans and deal with the emotions.
- Educate. Employ traditional scenario analysis to remind investors what happens if they miss those best days in the market and help investors re-engage with longer term investment ideas.
- Utilize model portfolios. Model portfolios built on a disciplined investment philosophy and strategic asset allocation can serve as a buffer against decisions driven by emotions or market timing attempts, keeping clients anchored to their long-term strategy.
- Establish agreements. Make a commitment with clients to revisit their financial plan before anything drastic is done to ensure the plan is still in place and makes sense for the client’s larger goals.
- Redirect biases. Turn potentially harmful biases into positive influences by reframing the narrative.
Advisors aren’t immune: recognizing and overcoming your own biases
Financial advisors are human, so they’re prone to biases, too. So it’s important to be cognizant of the emotions and behavioral biases impacting your investment decisions. Many advisors are affected by familiarity bias, for instance, and overweight the US equity market because they’re more familiar with it. Recency bias is another common trap, where advisors may overemphasize recent market performance when making investment recommendations.
After recognizing your own biases, you can employ practical strategies to overcome them and turn challenges into opportunities:
- Shift your perspective. Instead of being nervous about calling concerned clients during a period of volatility, think of volatility as an opportunity to reinforce your value. A downturn in the market can be viewed as an opportunity to buy more shares, for instance. If it’s a dark cloud, think about how to lean into the silver lining.
- Focus on prudent portfolio construction. Build diversified portfolio models aligned with investors goals using an established core strategy. This systematic approach removes emotion from investment selection and frees up time for higher-value activities like financial planning conversations around college savings, insurance planning, estate and trust work, and other areas where you can differentiate yourself.
- Understand portfolio positioning. Take time to thoroughly understand how portfolios are positioned before market events occur. Being prepared can enable confident, proactive discussions rather than reactive damage control.
- Limit emotional investment. Envestnet Unified Managed Accounts (UMAs) can help advisors overcome biases like overconfidence by delegating investment management to professional asset managers. This can remove the temptation to make bias-driven portfolio adjustments and allow advisors to focus on building client relationships and providing financial guidance where emotional intelligence, rather than investment timing, drives success.
Make behavioral finance your competitive advantage
Financial success isn’t always about numbers. It’s also about human behavior. By recognizing behavioral barriers and taking steps to overcome them, advisors can help clients make progress toward long-term goals and be the steady rock clients continue to turn to, despite fluctuating markets and emotions.
Envestnet can help you move your business forward. See for yourself at www.envestnet.com/schedule-demo
