Journal of Financial Planning: October 2022
Robert Glasgow has three years of experience working in the financial services industry for a major brokerage firm. He has his master’s in personal financial planning from Kansas State University and is currently pursuing his CFP® designation. He holds the Series 7, 66, 9, and 10 licenses.
Steven Meyers is a licensed clinical psychologist who is chair and professor of psychology at Roosevelt University in Chicago, Illinois. He is pursuing the graduate certificate in financial therapy at Kansas State University.
Courtney Walsh is a director at Portland Global Advisors in Portland, Maine. She is a graduate student at Kansas State University, pursuing a degree in financial planning. Blain Pearson, Ph.D., CFP®, AFC, is an assistant professor of finance at Coastal Carolina University, and an adjunct instructor at Kansas State University.
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Financial planning seems straightforward when examining the CFP Board’s standardized process. Financial planners begin by asking key questions to understand client situations, set client goals, and identify financial strengths and vulnerabilities. Financial planners then develop recommendations, present those recommendations, and implement the agreed-upon recommendations. However, there are disconnects that emerge when advisers offer recommendations and during the financial plan’s implementation. One such disconnect occurs when clients have overweighted positions in their portfolios, which they may adamantly desire to maintain. These concentrated positions may have resulted from a plethora of explanations, such as an inheritance, participation in an employer-sponsored stock plan, or from investments that have greatly appreciated relative to other investment positions. When working with novice investors and their portfolios containing overweighted positions, financial planners’ pleas for diversification may seem negligible to clients.
As of late, many amateur investors have been lured by the prospect of large gains from high-risk investments, as evidenced by the meme stock craze of 2021 and the introduction of cryptocurrencies and non-fungible tokens. Many new investors have even received much of their initial financial advice and preliminary financial education from social media platforms (Principato 2021). Many of these individuals have opened brokerage accounts for the first time, enticed by zero-commission trading platforms, which removed entry barriers to the stock, ETF, and option markets.
Beneath the surface of clients’ investment decisions are biases and other social and psychological pressures that divert attention from holistic investment best practices. “It might well be that investors are their own worst enemies, susceptible to cognitive and emotional errors and resistant to trade-off among wants. Indeed, there is evidence that some clients resist good adviser education and prescriptions, insisting on poor investments as some patients insist on antibiotics when medically unnecessary” (Statman 2020, 75).
The process by which we uncover client concerns becomes increasingly paramount when we understand the underlying reasoning for their resistance to diversify. Clients’ cognitive or emotional biases may serve as a roadblock, preventing clients from reaching their financial goals. Managing a client’s unwillingness to diversify requires active listening, knowledge of common biases, and adapting responses within an empathetic and explorative framework.
Biases and Investment Diversification Decisions
As it relates to investment diversification, common biases that can affect clients include familiarity bias, anchoring and adjustment bias, regret aversion, and overconfidence bias.
Familiarity bias. We are most comfortable in environments that are familiar to us. The same is true of investments. Basing portfolio decisions on investments that are familiar to the investor can lead to the portfolio being biased toward sectors and companies that are familiar to the investor. Whether a particular client is more familiar with CDs, annuities, the equity market, or a particular company’s stock, such familiarity can foster an environment that feels perceptually comfortable. Three common ways that familiarity bias manifests in overconcentration is through home-country securities, the company for which clients work, or simply a company they like or use regularly (McAndrews 2017; Pearson and Lacombe 2021). If the familiarity bias is left unmanaged, overlooked lucrative investment opportunities may go unnoticed.
Anchoring and adjustment bias. The value of any item, and the price that a customer is willing to accept for it, can be influenced by arbitrary anchors (Simonson and Drolet 2004). These reference points can be the price paid for a stock, the price of a stock at its last peak, or the price at which an investor considers the stock “cheap.” One vivid illustration that involved many younger investors is the meteoric rise of GameStop. The first time many investors became aware of GameStop’s stock was during 2021, when a popular subreddit on Reddit known as “WallStreetBets” encouraged its followers to purchase GameStop stock. The inflated prices that followed may have provided investors outside of that community an arbitrary and problematic reference point from which they inferred the value of GameStop stock.
Regret aversion. Regret aversion is a bias that is generally equivalent to the more colloquial term of “FOMO” or “fear of missing out.” The underlying reason causing a client to stick with the status quo is “fear that, in hindsight, whatever course they select will prove less than optimal” (Pompian 2012). As a default, many investors care more about what could have happened if they chose a different option. Regret aversion can result in the absence of participation in financial markets, holding losing or winning positions for too long, or adopting a “follow the herd” mentality to justify investment decisions.
It is also important to note that the degree to which a client feels like they missed out on an opportunity has more to do with if, in hindsight, the inferior decision was one of commission and not omission (Pearson and Guillemette 2020; Shafqat and Malik 2021). This bias alone may be strong enough to prevent a client from making a valuable portfolio adjustment. Likewise, with highly speculative positions that have fallen greatly in value, clients fear they may miss out on substantial returns if they make no adjustments. For clients where alternatively safer investments are the reference point, regret aversion can appear when additional portfolio risk is needed, yet not added.
Overconfidence bias. An additional emotional bias found among investors is overconfidence bias. Individuals who exhibit overconfidence bias tend to overstate their intelligence or abilities. If left unmanaged, overconfidence bias can result in excessive trading and holding concentrated positions (Mishra and Metilda 2015). Though studies show most investors exhibit overconfidence bias, other insights reveal that overconfidence bias is more predominant in men and inexperienced investors (Mishra and Metilda 2015). During the 2021 meme stock rally, investors flooded into single stocks like GameStop and AMC, driven by an irrational exuberance emanating from worldwide media outlets.
Individuals who believe they can become wealthy through a single stock may carry this belief throughout their life course (Statman, Thorley, and Vorkink 2006), leading to problems in asset allocation, including overconcentration and incurring unnecessary volatility and increased risk. Ultimately, novice investors with overconfidence may experience amplified problems, including a failure to meet financial goals due to an inability to accurately budget, save, or plan (Pompian 2012).
Recommendations from Financial Therapy
Financial planners generally rely on an educational framework for prompting their clients to make adaptive decisions. The underlying assumption is that sound investment principles, which are specific to the needs of the client, will be sufficient to produce the desired outcomes. Most financial planners also realize the limitations of this approach, as client decisions may appear irrational and guided often by simply emotion. Client education can help to fix errors, but facilitating self-discovery is often far more effective at influencing behavioral change when compared to a simple, short financial lesson.
Guided by principles from mental health and psychology, financial planners can use some basic interventions to help their clients navigate the cognitive and emotional biases described above. The foundation of these conversations rests in developing a solid working alliance with clients. In psychology, the working alliance refers to maintaining strong rapport with the client, having mutually affirmed and shared goals, and engaging in tasks that are likely to accomplish these objectives (Bordin 1979; Pearson 2021).
Rapport is created by respectful and careful listening. This is important, as it creates a sense of trust among clients. Many professionals bypass this step because they are eager to advise and get to the work at hand. When advice is seemingly discordant with a client’s preferences and understanding, the relationship becomes even more important, as it is the basis for change. Once rapport is established, then shared goals fortify the working alliance. This is important because individual investment choices can be measured against the notion of whether they further or impede progress toward the goals. The objective, ultimately, is to avoid seeming pedantic to the client, which may create a situation in which the client becomes more resistant in following the best practices of the professional.
The most straightforward way a financial planner can use financial therapy tools is to use a cognitive-behavioral approach. In general terms, cognitive behavioral therapy (CBT) identifies a distorted thought and then uses evidence to assess its rationality (e.g., Beck 2020). Rather than assuming that an individual is accurately appraising a situation, CBT acknowledges the irrationality and misperceptions that commonly occur in people’s lives. Within the area of mental health, a client may hold onto misperceptions that cascade into distressing feelings and maladaptive behaviors. Examples of distorted thoughts that therapists often encounter are “People are untrustworthy,” “I am never going to be in a successful relationship,” “I am always going to feel depressed,” or “My situation will never improve.”
Therapists who utilize a CBT perspective learn about clients’ stressful situations, can identify related distorted thoughts, and can then ask clients for evidence that both supports these troublesome beliefs and data that refutes them. In this way, CBT encourages clients to use a more “scientific” lens to examine their thinking from a balanced and objective perspective. Financial therapy adapts this paradigm for use with clients in ways that challenge the biases that we described earlier (Nabeshima and Klontz 2015).
In an ideal world, a financial planner would alert their client of the bias, a bias that the client may not be fully aware of. The client would then acknowledge the insight, and it would serve as a catalyst for behavior change. However, the recommended approach is more nuanced. The creation of a working alliance communicates that the planner understands the client’s motivations, emotions, and situations. The creation of a shared goal framework conveys that the professional is in alignment with the client’s aspirations. The use of a CBT approach then allows the financial planner to engage in a mutual and critical inquiry of the client’s biased assumptions in a way that is more akin to shared problem-solving than providing directions that may ultimately create resistance and dismissal. For example, in the case of overconfidence bias, the financial planner would frame discussion around their concern for the client to be as accurate as possible, in terms of their perceptions. The conversation can then move into identifying the core assumption at hand (e.g., “I can predict the market and I believe that investing in Bitcoin is the best way to earn the greatest amount of money”) and listing the evidence. Questions like “how would we know if this belief is right?” and “if we were to play devil’s advocate, how would we know if this belief is wrong?” can lead to a more objective appraisal of this assertion. Similarly, in the case of familiarity bias, the financial planner can help the client weigh evidence to rationally appraise the belief that familiar assets (i.e., ones that the client knows based on their own experiences or those popular among their peers) are the best. Guiding questions such as “how would we know if this is true?” or “is less familiar always less desirable?” can allow for reassessment.
Framing can be important when engaging in investment diversification conversations. For example, a “hidden opportunity” sounds more enticing when compared with a “foreign investment.” Ultimately, CBT challenges biases and misconceptions in both subtle and direct ways. For instance, using words like “this belief” rather than “you” side-steps defensiveness that clients often experience when a professional questions their perspective. In addition, this idea of shared wondering and examination underscores the fact that there is often flexibility in financial decision-making rather than assuming that there is only one right answer that applies across the board. Moreover, this approach implicitly relies on data to examine beliefs, which communicates that decisions should be based on evidence when possible and scrutinized.
Conclusions
Pompian (2012) reminds us that few could have predicted large companies, such as Lehman Brothers or Worldcom, would one day cease to exist, but no company is too good to fail. In bull markets, it is easy to ride the wave of constant growth, but the struggles of a bear market present challenges for clients. Through active listening, financial planners can determine whether the roots of a bias reflect a cognitive shortcut or an underlying and counterproductive emotion. Carefully worded questions can lead to self-discovered insights, which can ultimately help clients better appreciate the advice that planners provide.
Biases create obstacles for both novice investors and financial planners. Rather than exclusively educating or teaching clients, financial planners can become more effective when they use techniques that allow clients to explore their sources of motivation and biases. Financial planners can also better serve their clients when they reflect on the root causes of the behavior through empathic inquiry and discovery. This process can allow for the thoughtful examination of distortions in thinking that may otherwise hinder clients’ financial success and progress toward their goals.
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