How to rationalize the irrational

Behavioural science can be an invaluable tool in an advisor's battle against irrational client decisions

How to rationalize the irrational

Suffering a market loss often triggers irrational behaviour. As March and April reminded all of us, market downturns aren’t met with cool heads and rational decision making. Investors panic. They call their advisors displaying a range of emotional biases and demanding a sudden change in strategy. It’s these decisions, divorced from a rational understanding of market trends, that result in investors violating the fundamental rule of investing as they sell low and buy high.

The team at Manulife Investment Management has been preparing for irrationality. Knowing that markets correct and investors behave irrationally when they do, they’ve invested in a study of behavioural science, focusing on the value of the discipline as a tool advisors can employ to meet irrationality and address biases. In an upcoming webinar, behavioural science experts will share how advisors can help their clients overcome irrationality by nudging them back onto the right path. That process begins with empathy.

“If somebody is going through something emotional, people around them will jump in and just start talking and try to rationalize it to them. That’s usually the worst thing to do,” Says Catherine Milum, Head of wealth sales at Manulife Investment Management. “It's the same with investments. Good advisors listen. They hear people's thoughts out. They listen to what their worries are, and what their concerns are. That's the way you've got to start. It takes longer, but I think you get to where you need to go, because a lot of people won't listen to the rational side until you let them speak.”

Milum says that an advisor who listens well can then decide how exactly to go about addressing client concerns on an individual basis. She says that nudges are key. Rather than tackling a bias head on, risking confrontation and defensiveness on the part of your client, more gentle strategies are needed. That could involve shifting the conversation to mental accounting, showing the client that their finances are spread over several accounts. Advisors can explain how that money can be shifted around to compensate for losses in an investment portfolio or prepare for emergency liquidity shocks without derailing the client’s broad strategic goals.

David Lewis, chief client officer at BEworks and a PhD in consumer behaviour who is also a CFA, explained that investors are governed by a host of diagnosable biases in their decisions. Identifying and addressing them is key to advisors keeping their clients on a rational path. Though behavioural science has identified hundreds of biases, Lewis starts with four common biases that advisors will likely face from their clients: loss aversion bias, overconfidence bias, illusion of control bias, and representativeness bias.

“These are not biases that just affect us in the financial decision we make,” Lewis says. “These affect us in absolutely every consequential decision we make.”

Lewis demonstrates overconfidence bias with studies of driver confidence. Various studies have found that drivers consider themselves to have above average driving ability. For example in the US, 93% of drivers consider themselves to be above average in ability, which he says is mathematically impossible. In investing, too, Lewis says people tend to think they’re more capable than they are. A false confidence that manifests, during a drawdown, in an investor thinking they can do better than their advisor.

Illusion of control bias, according to Milum, comes from that part of your brain that says the Raptors didn’t win the NBA championship because of Kawhi’s talent, or Vanvleet’s shooting, they won because you wore your lucky socks. Though it’s an extreme example, we make a number of decisions because we think we have more control over our world than we really do. This bias makes investors think they can trade their way out of a downturn. What that usually results in, though, is a worsening of the existing losses.

Despondency and the expectation that the downturn will continue forever, according to Lewis, is a manifestation of representativeness bias. That’s the idea that what is happening now, will continue forever. The idea that the DOW Jones Industrial Average would hit zero after the 2008 crash was driven by this bias. The idea that a bull market will continue forever is the opposite side of that same coin. Representativeness bias directly results in the cardinal investment sin: buying high and selling low.

It’s the advisors’ job, according to Lewis and Milum, to tackle each of these biases with the right strategies and interpersonal approaches. The recent 2020 value of behavioural advice study supported by Manulife Investment Management shows that when investors receive advice informed by behavioural science, designed to meaningfully address biases, they hold their advisors and the advice they receive in higher regard.

“What advisors need to do is realize their role is as much a money coach, a life coach, and a psychologist, as it is a securities analyst and an economist,” Lewis says of the broad approach advisors need to take when dealing with client biases.

Lewis and Milum will break down each of these biases and present strategies advisors can use to address them in Manulife’s upcoming webinar. Register here.