– Editor's note: This article is the third in a series by CLS Investments CEO Ryan Beach covering his firm's research on advisor-client relationships. Read the first installment here.
Theoretical approaches to decision making assume rationality. However, early assumptions about how humans would make decisions, particularly with regard to finances, failed to account for how we as humans make choices in the face of uncertainty. The reality is that human beings actually make decisions by considering the probabilities of gains and losses associated with competing alternatives, rather than solely considering the end-state.
Behavioral economists were among the first to consider human irrationality in decision making. Research showed that in scenarios where people could choose certain loss of a small amount vs. possible loss of a great amount, people consistently chose the latter, because it had the benefit of uncertainty. The same model framed as gains led to the opposite result. As such, researchers concluded that utility in decision outcomes is a perception held by individuals, rather than an objective state.
But the reality is that human beings are far more complex than even this simple understanding allows. Three different investors with the same portfolios, information and risk often do not make the same choice — meaning that probability, odds, and systematic irrationality are not the sole factors that explain financial decision making. And so behavioral finance evolved to consider a wide array of cognitive and psychological mechanisms. There are three main areas to consider: cognition (biases, heuristics), biodata (experiences, demographics), and individual factors (personality, motivation). Let's have a look at each, to better understand our clients.
Cognition
In a perfect world, we would evaluate all information in order to make decisions. But the reality we must all come to grips with is that human beings do not have the cognitive and memory capacities to retain the vast amount of information available in most scenarios, let alone the resources to make decisions in that manner.
The problem is not the quantity of information, but rather that people are inherently poor at evaluating the relevance of various information presented to them, particularly in areas where they have less expertise (for example, investing/financial planning). In fact, there is research that shows that investors make consistently better decisions and are subject to less bias when advisors present them with information that has been aggregated.
Biases themselves are fairly systematic, and can account for a lot of the variance in financial decisions and investment success. One of our goals is to help advisors identify the various types individuals who are prone to a particular bias so that we might help you, the advisor, understand what you are up against when providing counsel.
The first such bias type is informational bias. These are the most common when examining what may have led us to decision failures. Confirmation bias, a subset, is where an individual lends more credence to information that confirms an already existing belief, and views information counter to that belief as more likely to be unstable or irrelevant. In financial situations, this may be why investors hold onto an investment longer — they may be overweighting the information that has a favorable view. People also tend to rely more on information that is broadly known and easily available, in some cases more so than perhaps information their own advisors may possess.
