The disposition effect, which is the propensity to sell winning stocks and hold onto losing ones, is a common behavioural bias, experts say.TeamOktopus/AFP/Getty Images
Human emotion can cause investors to make irrational decisions, such as panic selling during a market downturn or buying a high-flying stock based on overconfidence or fear of missing out.
Reactions such as these can have a detrimental impact on investors’ portfolios. By understanding the different behavioural biases that exist, advisors can act as “an emotional firewall” to help people avoid making poor decisions that could derail their financial plans, says Coreen Sol, senior portfolio manager with Solinvest at CIBC Private Wealth in Greater Vancouver.
Ms. Sol, who has written two books on behavioural finance, says the most common and persistent behaviour that gets investors into trouble is the disposition effect, which she describes as a “propensity to sell the winners and hang on to the losers.”
She says something interesting happens when investors see their investments grow: they feel good about the winners and, trusting their instincts, sell them to lock in profits.
“But what you’re doing is shooting yourself in the foot, because the winners, typically and statistically, will keep winning,” Ms. Sol says.
The disposition effect happens when one or more cognitive biases lead to poor decision-making: The investor who thinks their instincts picked a winner? That’s an example of confirmation bias, the tendency to process information in a way that confirms one’s beliefs. And the investor who sells the winners? That’s overconfidence bias, the tendency to overestimate one’s judgment and abilities.
Watch out for loss aversion
The propensity to sell the winners is compounded by the impulse to hang on to the losers – a bias known as loss aversion, which should be high on the advisor’s watch list, says behavioural science consultant Stephanie Bank at BEworks in Toronto.
“We have a much stronger response to losses than gains of equal value – and it really influences our decision-making around investment,” she says.
Loss aversion makes investors likely to retain poor performers because they’re motivated to avoid regret and avoid crystallizing their losses, Ms. Sol adds.
Uncertainty aversion is another cognitive bias advisors should recognize. It’s the human tendency to prefer certainty over uncertainty and known risks over unknown ones.
“We can’t sit with uncertainty,” Ms. Bank says, which is why investors feel anxiety in volatile markets.
Investors tend to make impulse decisions “as a tactic just to feel control, just to give them empowerment in times of uncertainty,” she explains.
If a person’s time horizon changes drastically – a long-term financial plan suddenly becomes an urgent “I want out now” request – they’re likely experiencing uncertainty aversion, Ms. Sol says.
Mind the ‘hot-cold empathy gap’
Another bias to watch for, Ms. Bank says, is the hot-cold empathy gap, which is an inability to understand or acknowledge the emotional sway of one’s attitudes, preferences and assumptions.
“We underestimate the influence of our visceral emotional states when we’re not actually in that state,” Ms. Bank says.
In a cool state of mind, an investor may be comfortable with their financial plan, but in a hot state, they might tell the advisor they can’t sleep at night. Even after they’ve cooled down, people discount the influence of their previously hot state: a panicked investor may calm down, yet remain convinced to sell.
Fear isn’t the only emotion at play. Overconfident investors can fall prey to the illusion of control, believing they can spot a winner or time the market, Ms. Bank says.
For instance, they may decide to sell stocks, believing they can call the top of a market, with plans to get back in later. Or, they may pause regular investment contributions and wait to try to buy during market dips.
“When overconfident investors are tempted to guess the peak or trough of the market, they’re relying on bias and emotion,” Ms. Sol adds.
Strategies to help advisors spot biases
Ms. Sol says advisors should encourage investors to use a dollar-cost-averaging strategy, which involves making fixed, steady contributions at regular intervals, such as monthly, regardless of the market’s performance.
“Regular contributions [are] a clear example of a good investment decision, especially during volatility because when prices drop, your contributions buy more units,” she says.
To help prevent clients from being influenced by biases, advisors should learn to identify those most likely to affect their clients and develop a list of strategies to overcome them.
Ms. Bank suggests creating rules to prevent impulsive decisions. An investor can set an “if-then” intention: if the portfolio drops by X per cent, my advisor will take Y action, much like a stop-loss order.
Setting rules reduces investor anxiety and lessens the temptation to constantly check one’s portfolio, which can induce feelings of loss aversion, she says.
Advisors should also encourage investors to focus on long-term objectives rather than letting short-term emotions dictate their decisions.
It’s critical for advisors to “remind investors of their financial plan, of their original risk tolerance, and encourage them to reference back to those plans,” Ms. Bank says.