Advising the Behavioral Investor: Lessons from the Real World
U.S. President Franklin Delano Roosevelt, during his first inaugural address in 1933, stated that “The only thing we have to fear is fear itself.” He made this statement when the country was in the throes of the Great Depression. More than 80 years later, academic research in the field of behavioral finance demonstrates that this celebrated line applies equally to investing. Investors are often their own worst enemies because they are susceptible to mental mistakes and emotional responses. These biases often lead to poor decision-making and, ultimately, inferior financial outcomes.
One of the greatest services a financial advisor can provide to clients is helping to ensure that in times of market turbulence, reason, discipline, and objectivity triumph over emotions such as fear, greed, and regret. This chapter explores some
reasons for which overcoming emotional and cognitive biases in investing is both vital to individuals’ long-term wealth creation and also a perennial challenge for financial advisors. It explains common emotional biases and how these impact the
development of investment strategy and, ultimately, investment results. Additionally, this chapter draws on both academic theories in the area of behavioral finance and the real-life manifestations of behavioral and cognitive biases on investors’ long-term wealth.
The chapter is organized as follows: The first section examines the complex relationship among risk, return, and the investor. Next, the chapter outlines several common emotional biases that can jeopardize an investor’s prospects for long-term wealth creation. The next section discusses the impact of investor behavior on portfolios, including why investors tend to underperform the asset classes and funds in which they invest. The chapter then details approaches financial advisors can use to help investors avoid emotionally driven decision-making and stay on track to meet their long-term goals. Finally, the chapter explores strategies that seek to turn predictable, common investor behavioral biases into profit opportunities.