Tips to overcome behavioral bias in investment strategies

5 tips to overcome behavioral bias in investment strategies

Behavioral biases can get in the way of investors' strategies. But financial advisors who understand the psychology behind how people make decisions can help clients identify the emotions that shape their thinking and make them better investors.

A new white paper by the investment firm Arnerich Massena, of Portland, Oregon, examined the findings of behavioral economists and came up with strategies for improving decision-making logic and processes. Advisors can play an important role in that, helping set and maintain a disciplined investment strategy to keep investors one step removed and able to retain some emotional distance, according to the paper.

Dan Grote, a behavioral finance advisor at Latitude Financial Group in Denver, said being aware of the mental shortcuts and emotions in the decision-making process is especially important to guiding clients in the currentmarket volatility.

"They can become reactionary and make emotional decisions in these moments," he said. "We can help them through that, giving them a firmer foundation and understanding of what their big-picture plan is and why we're doing what we're doing."

EY research found investor behavior shifts in the face of increasing market volatility, with over 70% of respondents saying they changed their investments due to a decline in portfolio value.

"Given the ongoing market volatility, investors have a lot of questions right now, and they are hungry for advice," Mike Lee, EY global wealth and asset management sector leader, said in a statement. "Continued market stress is amplifying their defensive stance and appetite for both switching and adding to their portfolio."

Overconfidence and confirmation bias are just a couple of the most common behavioral biases among investors, according to the paper. That means clients can overestimate their own skills, knowledge and abilities, and view information through the lens of their existing beliefs.

"These behaviors are very difficult to self-diagnose," Grote said. "It leads investors to continue a path of 'doing yourself' when it comes to their portfolios."

Scroll down the cardshow to see five tips from the white paper on how to overcome behavioral biases and maintain discipline in an investment strategy.

Identify the risk tolerance

A portfolio needs to balance investor tolerance for risk, otherwise volatility may become an overly emotional experience that can result in impulsive decision-making, the paper said.

It's important that advisors assess a client's risk tolerance and maintain perspective according to their time frame for achieving financial goals. Grote said he identifies his clients' top five to 10 values to anchor them in their decision-making processes.

"Having their values identified can be enough to shift them from being reactionary," he said. "That becomes of greater value during heightened stress periods."

Set asset allocation parameters and rebalance regularly

A portfolio needs to be balanced out, setting a maximum and minimum percentage range for each asset class, according to the paper. That helps the investor stay disciplined, keeping to the asset allocation over time and not being too influenced by market changes.

"Unless you make a conscious, tactical choice to adjust your asset allocation strategy, rebalance your portfolio at least annually to maintain your allocation within its range bounds," the paper said.

Be forward-looking

Historical data can provide context, but investors shouldn't make their decisions based on the past. A future-focused approach can help avoid behavioral bias such as gambler's fallacy, which suggests losses are bound to be followed by a win eventually, or the fallacy of sunk costs, a type of bias that keep investors tied to assets for longer than makes sense based on the hope of retrieving losses.

Maintain a long-term perspective

When assessing risk tolerance, it's important to set a long-term perspective to avoid making irrational short-term decisions.

"Long-term investors focus on certain key decisions to set their overall strategy; once set, they don't need to become consumed with short-term market movements and volatility," the paper said.

Challenge beliefs and decisions

Just like anyone, investors are susceptible to being overconfident, using whatever information is easily and immediately available, and sticking with the majority opinion instead of their own. These behaviors shape the way they view their facts, analyses and eventually their decisions.

Implementing a formal review process of their past decisions and questioning their insights can help investors look at their strategies from different angles, the paper said.

"Ultimately, we want our clients to become better investors," Dave Janec, senior investment advisor at Arnerich Massena, said in a statement. "An understanding of behavioral economics is important for anyone making financial decisions, but particularly for those working to build a long-term investment portfolio."