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Clients have biases that affect you, too

Two of the precepts of behavioural finance are overreaction and availability bias. Studies have shown we overreact to newer information, both good and bad.

We’ve seen collective overreaction send market prices up higher or lower than is appropriate. This surge or decline in price tends to diminish over time. However, investors acting at the beginning of the cycle can overpay for their investments or sell at too pronounced a loss.

Availability bias means investors value newer or easily obtainable information more than older or more elusive information. The problem is, there is often nothing to suggest the newer information is better.

In fact, the competitive nature of a 24/7 cycle of business news means networks are always racing to publish information, sometimes without providing sufficient context for viewers. As a result, the potential for making bad decisions has increased.

The lesson is to have a longer-term perspective when investing. Remembering the past can modify your view of the present.

Ask your client questions about their feelings when they’re making a rash decision. Why do you believe this latest news is important? Have you ever reacted to news and made a quick decision? How did that work out? How will this help you achieve your long term goal?

The objective is to uncover the feelings and attitudes of clients—right-brain activity—and slowly move them to thinking with their left brains, the logical part, by listening, empathizing, and asking questions. By doing this, you can steer them away from potentially dangerous behaviour.

Don’t rush. Probing will help you lead them to feel their emotions about their retirement, and move from the short-term negative to the long-term positive.

Use examples with clients

Take a look at one week on the stock market as reflected by the Dow Jones Industrial Average. The period covered is from September 30 to October 6, 2011. The closing value of the index was 10,913 on September 30 and the closing price on October 6 was 11,123.

However, if we think of the headlines and the emotions investors felt, this graph is a good reflection of their feelings.

Despair, anxiety, then relief. Not much peace of mind in that five day period.

Many people overreacted to the headlines of the Friday and Monday. Had they reacted out of fear and sold, they lost the recovery. Many did, as there was a big outflow on the negative side in mutual funds in September.

Coaching clients to change their focus from the events of today to the long-term plan and the future will ultimately lead to more client peace of mind and a happier relationship with you, their advisor.

Who advises the advisors

Advisors have to be mindful we don’t fall prey to the same biases of our clients. We are inundated with so much business news, product launches, and information from manufacturers that many advisors can be overwhelmed. Although it’s tempting to act on this information, I ignore 90% of it.

Instead, become familiar with behavioural finance, understand the cognitive and emotional behaviours of clients and learn how to deal with them.

Behavioural finance can identify the common tendencies people have when they are threatened or forced to make decisions in a stressed environment. Understanding how clients feel and understanding your own reactions will help you respond to your clients effectively.

Gary Gorr, CHFC is a behavioural investment funds advisor trying to help Canadians answer the question: Will you outlive your money or will your money outlive you?

Originally published in Advisor's Edge Report