Financial markets are not efficient. The main reason why is because most financial decisions are affected by cognitive biases which often cause less than optimal choices. These biases are reduced a bit by greater intelligence and financial literacy, but this advantage goes out the window when the bias is emotionally driven.
Two of most effective biases that cause bad decisions concern herding – doing it because everyone else seems to be doing it, and overconfidence – I’m too smart to make a mistake. The internet has exploded the power of the herding bias since a consumer is bombarded with similar stories. A decade long bull market has raised overconfidence levels in general. In addition, the ability of, essentially, financially illiterate and financially unqualified consumers to impulsively buy stocks, options and cryptocurrency have been augmented by new internet brokerages. Unlike in the past, regulators have to date done nothing to safeguard consumers from these new threats. However, here are four ways financial professionals can help their clients improve decision making.
Financial Literacy – schooling consumers on the reality of risk and returns can lessen impulsive decisions. Teaching about lesser known instruments, such as fixed index annuities, provides new solutions that have not been considered.
Framing – talk about loss before gain. Asking whether the consumer can handle possibly losing half of their money or more – as often happens when bubbles burst – results in better decisions than starting with how much might be made.
Recognize Emotions – rational economic man or woman is a myth. Facts are often ignored when emotions hold sway. The most effective course may be to delay acting on the decision and hoping the emotional peak passes. It’s not showing the consumer why they are wrong – because they won’t be receptive to facts, but asking them to wait until things quiet down…new information is received…your computer is back online.
Herding – this can be used for good. If a consumer is unfamiliar with fixed annuities, mentioning that over a million of his neighbors purchased one last year makes one wonder if they are missing something. They may never have heard of fixed index annuities, but FIAs have more assets than any cryptocurrency (and, unlike cryptocurrency, no fixed index annuity owner has ever lost money because the market went down). [Advantage Compendium, September 2021]
Biases have always been a factor in decision making. Unfortunately today there are financial firms that intentionally use specific biases to target susceptible consumers into making less than optimal decisions. This, coupled with social media and the internet, has enabled consumers to make bad decisions more quickly and with greater self-damage. Financial professionals play an essential role in helping to protect consumers from damaging biases and making bad decisions.
Copyright 2021. Prepared for AMS Financial Services Group (AMS) by Advantage Compendium, Ltd. for educational purposes only. Neither AMS nor Advantage Compendium, Ltd. provide investment, tax or legal advice. Information believed accurate, but is not warranted. Any views expressed are not those of AMS. Reproduction is not permitted without written permission. Fixed annuities typically have penalties for early withdrawal, known as surrender penalties, which may cause a loss of principal if the annuity is cashed in prematurely. Past performance is not an indication of future results. No index sponsors, promotes, or makes any representation regarding any index product. Both investments and fixed annuities involve certain risks; a consumer should consult with their advisor. Fixed annuities are not bank instruments and are not insured by FDIC.