What are ways to mitigate biases that interfere with rational investment decision-making? In their September 2019 paper entitled “The Psychology of Financial Professionals and Their Clients”, Kent Baker, Greg Filbeck and Victor Ricciardi describe common psychological biases and suggest ways to overcome them. Based on their knowledge and experience, they conclude that:
- A straightforward way to classify biases is:
- Cognitive – deficiencies or limitations in collecting, processing and interpreting information, manifested as: (1) ignoring or minimizing new information that conflicts with a prior belief; and, (2) failing to distinguish between relevant and irrelevant information.
- Emotional – spontaneous and deeply ingrained irrational responses to positive or negative information.
- Cognitive biases are generally more correctable than emotional biases.
- Strategies for mitigating cognitive biases include:
- Confirmation bias – make a list of contrary beliefs by seeking and reflecting on sources that look at things differently.
- Illusion of control bias – explicitly distinguish between controllable and uncontrollable aspects of investing outcomes.
- Hindsight bias – keep a journal of investing decisions and contemplate alternative explanations for outcomes.
- Framing bias – maintain objectivity, focus on total return and risk rather than gains and losses, and consider different perspectives on investments.
- Mental accounting – create a written financial plan that addresses the entire portfolio and translates separate investment buckets into their intended tangible uses.
- Familiarity bias – systematically seek unfamiliar asset classes and strategies for opportunities to increase diversification and reduce risk.
- Strategies for mitigating emotional biases include:
- Overconfidence and overoptimism bias – make decisions deliberately (slowly) and solicit second opinions.
- Loss aversion – recast “sell” decisions as hypothetical “buy” decisions, or use preset rules for when to sell winners and losers.
- Regret aversion – recast opportunities as decisions whether to maintain the status quo, and stick to the investment plan (especially during down markets).
- Status quo bias – adopt periodic portfolio rebalancing rules and/or continually revisit potential benefits of reallocation.
In summary, financial advisors and investors can mitigate psychological biases that lead to suboptimal investment decisions via deliberate, systematic, careful and open-minded planning and execution.
However, note that identification and analysis of financial biases implicitly assume a “rational world” benchmark that specifies optimal investment behaviors. The authors do not make a case that such a benchmark exists or is possible.
