Dealing with behavioral biases

Parag Parikh
Human thought processes are an amalgam of experience, intuition and rationality. Our actions are usually based on the belief that we know what is good for us. However, many times those actions are based on impulses which may actually be detrimental to us in the long run. Also, since the feedback mechanism is often not instantaneous, we bear the consequences of our actions much later. By that time it may be too late to remedy the situation. This behavioral tendency is visible in every aspect of our lives be it education, health, money, relationships etc.

While academics steadfastly cling to the ephemeral notion of “Rational Man”, there is an irrefutable and growing body of evidence contradicting this. If humans were truly rational, then all of them would have behaved in a very similar manner. For instance, the traditional regimented route to success is : Finish your schooling, go to a “reputed” college, pursue a “safe” degree and get a “good’ job, which until recently meant either a doctor, engineer or lawyer.

However, over the years, an increasing number of students have chosen to go on the road less travelled and guided by their heart, have chosen off-beat courses such as wild-life photography, linguistics, etc. At the outset, virtually no one knows whether they will be successful or not. However, that does not deter them from putting in their best effort. My point is, even in a relatively unadventurous field such as formal education, many a time, the heart rules the head.

Coming back to the core subject of this article, whenever clients visit advisors, they expect us to solve all their financial problems and want us to assist them in attaining all their financial aspirations. However, I have observed that they display several cognitive and emotional behavioral biases while interacting with us. Here are a few of them:

Optimism Bias:
Many a time, clients visit us after they have experienced some kind of financial trouble. It could be related to debt burden, the tendency to over-spend, a job loss etc. At that point they are overly optimistic about our ability to provide quick-fix solutions and immediately get them back on track. Often they fail to comprehend that it takes a joint effort on the part of both, client and advisor, to emerge out of the rut.

Representative Bias:

Many times clients compare us to their family doctor and expect that we will provide them with the equivalent of tablets which will help them recover in a few days. While, it is true that there are some parallels between the two professions, we are more adept at providing solutions which will help you in the long-term rather than the short-term. In other words, feedback mechanisms are often not instant, in our case. On a lighter note, I think it would be better if they compared us with to dieticians rather than cosmetic surgeons.

Sunk Cost Fallacy:

Clients persist with products which are unsuitable for them, simply because they have paid for them. Investment oriented insurance policies are good examples. The policies that they currently own may provide a low life cover and may be opaque & difficult to understand, Yet they are reluctant to surrender them, despite us pointing out better options. This is because they have already paid the premium for the past few years. Consequently, they are unwilling to bear any surrender-related losses, even if rationally they should be agreeing with our contention that in the long run it would be costlier to continue with the policy.

Confirmation Bias:

Often, certain long-standing beliefs have already ossified in clients’ minds when they approach us and it is difficult to suggest something which is contrary to these. For instance, if we suggest increasing equity exposure to an avowed debt investor, he may diligently point out all recent instances when the equity market has crashed. At the same time, he will not accord any weightage to the stellar cumulative performance of the stockmarket over the past two decades or so.

In other words, he will cling on to examples which fortify his belief that stocks are risky and conveniently ignore the ones which disprove this belief. To such people I cite several examples of companies reneging on their debt obligations.

Bandwagon Effect:

Everyone is more bothered about what the others are investing in rather than researching which product suits them the most. For instance, over the past one year, when Fixed Maturity Plans (FMPs) were in vogue, many of our clients were keen on opting for one year FMPs merely because some acquaintance or the other had done so.

This included clients who needed to utilise the same money within the next six months and for whom the illiquidity of the FMP was a big negative. It took a monumental effort to make them jettison this idea and convince them to park their capital in short term debt funds.

While there are many more such biases, the moot point is that while dealing with humans (and especially on a touchy subject like their finances), advisors must treat irrationality as “par-for-the-course” and not be surprised at anything that confronts them. This is more art than science. That is where experienced advisors score over the rookies who merely go by what their courseware states.

 

2 Comments

  1. As usual, spot on, Sir! Personal Finance is more about psychology than numbers, analysis, etc.

    Sir, can i republish this on my website with due credits to you? Thanks for such insights!

Leave a Comment.