Why behavioral finance is important in today's market environment

Market volatility can make even the most seasoned investors nervous, so with the 10-year bull market expected by many to end soon, it's important that advisors understand how attitudes, preferences and biases can impact investor decision-making.

Behavioral finance—the field that combines psychology, economics and other social sciences to identify and understand why people make certain financial choices—can help advisors develop long-term relationships with their clients and build portfolios better suited to their clients. Investors are human, and therefore have the tendency to make emotional, biased investment decisions. Advisors who understand the psychological or emotional factors that predispose investors to behavioral biases can differentiate their services and ultimately better serve their clients.

To raise awareness about the impact behavioral biases can have on investors and advisors, Charles Schwab Investment Management and the Investments & Wealth Institute have teamed up to host Behavioral Finance Week. Throughout the week of September 23, the two organizations will share information, resources and tools on behavioral finance, including a new study they sponsored with Cerulli Associates, the BeFi Barometer 2019.

In honor of Behavioral Finance Week, I spoke to Omar Aguilar, CIO of equities and multi-asset strategies at Charles Schwab Investment Management, to discuss behavioral finance concepts and why it's important to understand them in this market environment. Omar holds a PhD from Duke University's Institute of Statistics and Decision Sciences, and has been analyzing global equity markets through a behavioral finance lens for more than two decades.

What are the core principles of behavioral finance, and why is this field important in today's market environment?

Omar: Human nature is complex, and behavioral finance studies how emotional, cognitive, and psychological factors influence investment decisions. Thousands of studies have confirmed that human beings are perfectly irrational in their decision making. Behavioral finance helps to explain the difference between expectations of efficient, rational investor behavior and actual results.

In the midst of heightened market volatility, advisors will need to focus on behavioral aspects of wealth management, and develop a greater understanding of how biases impact clients' investment decisions. Incorporating behavioral finance into their practice is key to enhancing the client experience, deepening relationships, retaining clients and delivering better outcomes.

How do biases show up in investor behavior or decision making, and how can they be detrimental to long-term financial goals?

Omar: Behavioral finance proposes psychology-based theories to explain stock market anomalies (e.g., dramatic rises or falls in stock price), and to identify and understand why people make certain financial choices. Individual behaviors and thoughts impact spending, investing, trading, financial planning, and portfolio management. The market is not one person, of course, but it represents the collective actions of individuals whose personal behavioral biases may be more or less dominant depending on their unique experiences.

As bubbles and busts have unfolded over the last three decades, the insights into market behavior provided by behavioral finance have become harder to brush aside. First, even if prices are rational and investors are not, that still leaves a huge potential source of friction. Absent some framework for managing that disconnect, rationalizing investors' expectations with their actual needs becomes a perpetual challenge.

Do behavioral biases differ among generations? If so, can you talk about the most common biases you see by different age groups, and why we might see those discrepancies?

Omar: Addressing clients' generational biases can lead to more effective communication, stronger client relationships and better investment outcomes. For example, Millennials are most likely to fall prey to herding bias, which is the propensity to gravitate to the latest investment trend for fear of missing out. Baby Boomers tend to have anchoring bias (a tendency to focus on specific reference points when making investment decisions) and be overconfident. They like to take risks and believe that markets will eventually deliver positive performance. Finally, Generation X tends to observe recency bias (being easily influenced by recent news events or experiences) the most.

Can you talk a little bit about recency bias and what it means when markets are volatile?

Omar: Recency bias often manifests itself by seeking information that reinforces established perceptions. In volatile markets, investors may underestimate the risk in their portfolio and rotate towards safety assets without any economic or fundamental reason for it. Conversely, positive short term gains can lead to investors taking unnecessary risks.

New research shows that recency bias is the number one behavioral bias advisors observe impacting their clients' investments decisions.

Often investors work with advisors who are not immune from holding biases themselves. What are the top biases that impact advisor perspectives and decision-making?

Omar: We're all human, so all investors, advisors and professional money managers are subject to biases. Advisors tend to be risk averse therefore loss aversion is the most prevalent bias. Feeling worse about losses than gains is the most relevant behavioral bias that affects their decision making.

How can investors mitigate these risks?

Omar: To mitigate these risks, the main objective for advisors is to find the right balance between what their clients want and what their clients need. A robust portfolio construction process with a disciplined and systematic implementation plan can provide a solid framework to mitigate biases and enhance client outcomes. Advisors should look to understand their clients' needs and biases, and then adjust client needs and the initial asset allocation to account for these emotional and behavioral biases. Advisors that can recognize the risk profile of their clients during the portfolio construction process will be more prepared to deal with behavioral biases as they arise, and help clients stick with their long-term plans, therefore providing better outcomes.

At CSIM, we have a program, Biagnostics, that can help advisors incorporate behavioral finance into their practice. It's designed to create an emotionally and financially customized client experience by addressing behavioral biases and generational challenges.

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Jonathan de St. Paer
President and Chief Executive Officer, Charles Schwab Investment Management

About the author

Jonathan de St. Paer

Jonathan de St. Paer

President, Chief Operating Officer