The Science Behind Better Decision Making
Investors can be their own worst enemies. Behavioral economics explains what goes wrong—and how you can help clients avoid missteps.
Dec. 12, 2022 - If you could save $100 on a $200 purchase and had to drive across town to get the deal, you’d probably hop in the car quickly. But if you could save $100 on a $10,000 purchase that required the same trip across town, you likely wouldn’t bother. Yet that mental accounting doesn't hold up to rational thought: you'll save the same $100 on either purchase and both trips involve the same effort.1
Welcome to the world of behavioral economics—the intersection of finance and psychology. Classical economics assumes that people are 100% rational and make decisions about personal finance and investing based on their self-interest, using only cold, hard facts.1 Behavioral economics—also known as behavioral finance—reflects how people make decisions in the real world. Because investors are human and subject to emotions, they often fall prey to biases, emotions, perceptions, and other factors that can lead them astray.2
The good news is there are some specific strategies that can help your clients avoid making these mistakes.
A Closer Look at Biases
Behavioral economics looks at the biases that influence decisions. You can think of biases as mental misfires—glitches in how people perceive a specific situation and make sense of it. There are many such biases, but here are some of the most common:
- Self-attribution: First, investors may sometimes take undeserved credit for a good decision. For example, if they pick a winning investment, they will likely attribute it to their own skill. If they choose a loser, they’ll blame the market.3
- Loss aversion: Investors also tend to feel the pain of a loss far more acutely than they feel the joy of a gain—even though both outcomes should have roughly equal weighting—and they shy away from decisions that may lead to a prospective loss. As a result, they may not want to take an appropriate level of risk.4 In the current market, where most investors are seeing steep drops in parts of their portfolio, loss aversion may push them to take action to prevent further losses. Yet selling in a down market is rarely a good idea.
- Herd behavior: People often make investment decisions simply because they heard about someone else doing something similar.2 That behavior can lead to speculative bubbles like the dot-com boom or the recent run-up in certain types of cryptocurrencies—both of which ended with sharp losses.
All of these share a common underlying cause—they’re based more on feelings and intuition than on rigorous quantitative analysis.
Making Better Investing Decisions
How can investors do better? For one thing, simply knowing how these biases affect investor decisions can help by pushing people to stress-test their choices and question the underlying rationale for a change in their portfolio. As a financial professional, you can reinforce your value by continuing to educate them about behavioral economics and common investing mistakes.
In addition, given that behavioral economics plays out through questionable investor decisions, one part of the solution is to make fewer decisions. Putting investing decisions on autopilot—such as dollar-cost averaging or automatic portfolio rebalancing at fixed intervals—can help prevent your clients from trying to respond to fluctuations in the market.2
Last, a well-balanced portfolio with a broad mix of asset classes, including non-traded alternative investments, can help mitigate investor biases and questionable decisions—especially in volatile markets like the current one. In general, alternatives tend to be less liquid; they typically don’t trade on a secondary market, which eliminates the temptation for investors to sell them off during market disruptions. That way, they can serve as a buffer from short-term decisions that often hurt long-term returns.
There are additional benefits from the illiquid nature of most alternatives:
- The asset prices are less influenced by market sentiment and, thus, their value more closely aligns with the value of the underlying assets. This helps mitigate the ups and downs of the short-term market and can help ease the emotional effects of loss aversion for investors.
- The managers who oversee alternative asset classes don’t have to worry about meeting redemptions. Just like the investors whose capital they hold, they can focus less on short-term volatility and more on a long-term strategy.
Non-traded investments carry their own specific risks, including illiquidity and higher fees, and they may not be suitable for all investors. And illiquidity means that investors can’t withdraw their investment should they need rapid access to their underlying capital. However, there may be value in allocating to private investments from both a financial and behavioral perspective.
Investing can be challenging in today’s volatile publicly traded markets, but it’s even tougher when investors don’t see the whole picture and make truly subjective decisions. With an understanding of behavioral economics and a diversified portfolio, your clients may avoid these common pitfalls and make better decisions. Potentially leading to better financial outcomes with less emotional angst.
Represents CNL’s view of the current market environment as of the date appearing in this material only. There can be no assurance that any CNL investment will achieve its objectives or avoid substantial losses.
1 Max Witynski, “Behavioral economics, explained,” University of Chicago News, accessed Nov. 7, 2022.
2 JPMorgan Wealth Management, “The lovechild of psychology and investment strategy: Behavioral finance,” Chase.com, Feb. 4, 2022.
3 Melissa Lin, “Why Investors Are Irrational, According to Behavioral Finance,” Toptal.com, accessed Nov. 7, 2022.
4 Andrew Rosen, “Loss Aversion: Don’t Let Cognitive Biases Influence Your Retirement Accounts,” Forbes, March 10, 2022.