Morningstar Advisor - October/November 2009 - 34

Spotlight 20 Most Common Investment Biases Type Bias Effect Emotional Endowment Loss Aversion Status Quo Regret Optimism Overconfidence Self-Control Overvalues own investments regardless of expected outcome. Feels pain of losses more acutely than the pleasure of gains. Chooses option that will keep conditions as they are. Avoids making a decision because of fear of poor results. Believes bad events can happen only to others. Holds an unwarranted faith in own abilities. Spends today at expense of saving for tomorrow. Clings to arbitrary pricing levels when considering an investment. Categorizes sums of money and treats them differently. Overemphasizes events that are most recent. Perceives that an event was predictable, even when it wasn’t. Is unduly influenced by context in which choice is presented. Rationalizes a poor decision. Prefers ambiguity-free options even when they seem less likely to succeed. Sticks to initial view or forecast despite new information. Estimates probability of outcome based on prevalence in one’s life. Seeks out information that supports preferred position and avoids information that undercuts position. Lets pre-existing ideas influence how new information is processed. Ascribes successes to innate talents and blames failures on outside influences. Believes that one can influence events that are out of one’s control. Cognitive Anchoring Mental Accounting Recency Hindsight Framing Cognitive Dissonance Ambiguity Aversion Conservatism Availability Confirmation Representativeness Self-Attribution Illusion of Control list which type each bias is: cognitive or emotional. Both cognitive and emotional behavioral biases yield irrational judgments. Understanding the differences between the two is important because planners must advise emotionally biased clients differently than cognitively biased clients. Cognitive biases are the results of basic statistical, information-processing, or memory errors that are common to all people. Think of them as “blind spots” or distortions in the human mind. Cognitive biases do not result from a predisposition toward certain judgments but rather from subconscious mental procedures for processing information. Because cognitive biases stem from faulty reasoning, education and advice often correct them. On the opposite end of the spectrum are emotional biases. Emotions are physical expressions, often involuntary, related to a person’s feelings, perceptions, or beliefs. Emotions can be undesired; a person may wish to control feelings but cannot. Because emotional biases originate from impulse or intuition rather than conscious calculations, they are difficult to correct. Advisors must make emotional connections to clients of this type to get them to make morerational decisions. Figuring out which investment biases each of your clients has and determining how the results fit into formulating an investment plan is a complex and time-consuming process. This “bottom-up” approach is doable but not very efficient for most advisors. (I detail this approach in my book, Behavioral Finance and Wealth Management.) Instead, I’ve developed a simpler system. I call this “top-down” approach Behavioral Alpha. Behavioral Investor Types assessments of the kind of investor they are dealing with upfront in the investing process. This will avoid surprises later when clients, in reaction to an unexpected event such as a market meltdown, will inevitably morph from homo economicus to homo sapien. In a sense, the goal is to limit trauma. Advisors who deliver smooth (and expected) results because they had created an investment plan that was customized to a client’s behavioral makeup have strong client relationships as the result. Behavioral Alpha first classifies clients into one of four behavioral investor types: Passive Preservers, Friendly Followers, Independent Individualists, and Active Accumulators. Each behavioral investor type is associated with distinct investor biases. Once advisors determine which one of the four investor types a client is, they will know the most common biases people of this type have. Obviously, the world is too complicated to be able to neatly categorize all investors into Behavioral Alpha is an approach that allows advisors to make rapid yet insightful 34 Morningstar Advisor October/November 2009

Morningstar Advisor - October/November 2009

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2009