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April 01, 2013 at 08:00 PM
Financial advisors are constantly barraged with questions from their clients like, “Why is this fund not up as much as the market?” or “Why don’t we invest in just a handful of top performing stocks to get better returns?” Behind each of these questions there could be a behavior disorder lurking.
“As a wealth manager, I have found the value of understanding the behavioral investor types of clients,” writes Michael M. Pompian, CFA, in his book Behavioral Finance and Investor Types (Wiley, 2012). Pompian’s book uncovers the personality profiles for different investors in an effort to help advisors to better comprehend client behavior.
Back in the late 19th century the theory of “homo economicus” suggested that humans are inclined to make rational financial decisions. Since then, empirical studies have shown the exact opposite; people are prone to make investment choices that aren’t always the right ones.
Let’s analyze behavioral traits that get investors in trouble:
Illusion of Control Bias (ICB)
The ICB person believes they can control or influence the outcome of their investments, when in reality, they cannot. To illustrate this, Ellen Jane Langer, a professor of psychology at Harvard University, observed how people select lottery tickets.
In one of Langer’s studies, people were allowed to participate in a hypothetical game of lottery. The individuals who were allowed to choose their own numbers were willing to pay a higher price for their tickers compared to others who were willing to have their numbers randomly selected. Although the people who chose their numbers may have felt a psychological advantage, it didn’t increase their chances of winning.
