Traditional finance assumes that cognitive biases play no role in human beings' decision-making processes whereas the body of behavioural finance attempts to explain these biases through understanding the human intrapsychic systems — our patterns of thoughts and beliefs based on life experiences, current moods, personal affects and biases that alter decision-making outcomes. There's now a theory that recent advances in artificial intelligence (AI) and social media will reduce these emotional biases and move investors toward the traditional finance process.
However, a recent study from Wilmington, Del.-based investment research firm BeyondProxy LLC discovered that "There is no evidence that online collaboration and sharing of information is anywhere close to reaching the tipping point to diminish the principles of behaviour finance." To the contrary, "During periods of high market volatility, social media conversations can amplify investors' behaviour biases in investment decision-making."
Therefore, even as technology is transforming the nature of conversations with clients radically, understanding clients' emotional biases should remain a focus within the client engagement process for financial planners and financial advisors.
To further highlight this point, social media can provide better information and AI systems can calculate rational outcomes, but the collective social mood can cause investors to make irrational financial decisions as a group. Social mood may be caused by external events in an investor's social community or a country as a whole. For example, the S&P/TSX composite index lost as much as 12% in three weeks after all Canadian teams lost the first round of the National Hockey League playoffs in April 2012. In fact, some theorists propose that social moods drive markets up or down — not vice-versa.
It's critical to solve and manage these intrapsychic systems to maximize wealth for clients over their own life cycle and especially across generations. Michael Pompian outlines the following most common human investor types, associated biases and managing strategies, in his book, Behavior Finance and Wealth Management:
> Type 1: The Preserver
Passive investors who value financial security and wealth preservation far more than growth. They're highly risk-adverse and losses are much more painful than the joy of gains.
Bias: Loss aversion. These investors most often will sell their winners and hold on to their losers hoping to recoup losses even at the expense of more losses.
Strategy: Slow and steady. These investors should not invest aggressively regardless of age and time horizon as they may be unable to stick to their investment plan during periods of market volatility. They should employ less risky, slower growing investments and other methods such as higher savings;
> Type 2: The Follower
Passive investors who tend to be compliant in taking advice from friends, family and colleagues, but who can be prone to making abrupt investment decisions at the urging of trusted friends and media commentators.
Bias: Regret. Followers fear regret and may undergo stressful emotional processes when threatened with the idea they may make a wrong or unfavourable choice. The result is that no choice is made and a desirable outcome may be missed.
Strategy: Stay the course. Followers should consider whether or not advised changes are in line with their long-term goals and refrain from snap decisions that may shift the long-term expected risk and returns of their portfolios dramatically.
> Type 3: The Independent
Active investors who can act quickly and decisively, and are confident in their own research. They study more than most and are avid consumers of information, and appreciate data over emotions when making decisions.
Bias: Conservatism. Independents may become overconfident in their own research and make major decisions based on a positive or negative market outlook that can put their long-term goals in jeopardy. They favour initial data or impressions over new data leading to inflexibility in attaining the most favourable outcome.
Strategy: Match the market. Independents are analytical and like to discuss their investments and holdings with their advisors. They need education and metrics to counteract personal biases. The best strategy is to invest in long-term market growth while remaining agile to reduce risk and capitalize on opportunities where possible.
> Type 4: The Accumulator
Active investors who are risk takers and have a strong conviction in their ability to be successful investors.
Bias: Overconfidence. The main mistake accumulators make is that they often have a false sense of control and are prone to taking unnecessary risks in their investments. They often struggle to follow a consistent long-term strategy and may make dramatic short-term allocation changes based on their own market direction beliefs.
Strategy: Look for blind spots. Accumulators may self-select data to reinforce their own views. They need data that may be contrary to their preconceived beliefs to ensure that they have a balanced analysis before making important investment decisions.
It will be a long time before AI replaces the "human" in humans, so financial planners and advisors will need to hone their people skills to understand the emotional biases of their clients well into the future.