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  • Home>Practice Management>Practice Builder>A Closer Look at Investors' Cognitive Biases

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    A Closer Look at Investors' Cognitive Biases

    By further categorizing cognitive biases into belief perseverance and information processing, advisors can better understand their clients' behavior and help them make better decisions.

    Michael M. Pompian, 04/18/2013

    This month's article is the fourth in a series called "Building Better Client Relationships by Understanding Investor Types." This series is intended to help advisors create great working relationships with their clients by taking a step back and understanding the type of person they are dealing with (from a financial perspective).

    Individuals are different in the way they process information, vary in the way they behave when faced with a financial decision, and have different risk preferences, so it is essential that advisors interact with each client effectively. This often means that you must change the way you speak to different types of clients even though your advice may be similar across your client base.

    Some advisors fail in their tasks not because they don't have technical knowledge of the markets, understand the strategies of investment managers, or have systems that can deliver the best methods of portfolio construction, but rather because they don't understand what is truly important to the client and how to communicate and interact in a way that is meaningful and effective.

    As you know by now, I have dedicated a substantial amount of time promoting the benefits of behavioral finance research and making it accessible to large numbers of financial advisors. In my latest book, "Behavioral Finance and Investor Types," my primary objective was to simplify the practical application of behavioral finance by boiling down many of the complexities involved in diagnosing and treating behavioral biases into the simple concept of investor types, which I refer to as "behavioral investor types" or BITs. BITs are defined in large measure by the biases themselves and are categorized in a way that makes intuitive sense and can be easily understood.

    The Foundation of Behavioral Investor Types
    In order to fully grasp the concept of behavioral investor types, it is essential that we take some time to explore my categorization of behavioral biases. The biases are grouped in a way that will lead directly to each type. Once you understand how biases are defined and grouped, you will understand the foundation of each BIT.

    In this article we will continue building the foundation for understanding each type to give you a better understanding of how BITS are created--with the ultimate goal of using them in practice. Today I will refine the cognitive vs. emotional framework, which will help you to deal with the cognitive biases of clients. In the next article, I will introduce the behavioral investor type framework.

    In the last article, we defined cognitive and emotional biases. Cognitive errors stem from basic statistical, information processing, or memory errors; they may be considered the result of faulty reasoning. Emotional biases stem from impulse or intuition and may result from reasoning influenced by feelings. Behavioral biases, regardless of their source, cause deviation from the assumed rational decisions of traditional finance. As I have discussed on many occasions, emotional biases are difficult to correct, and a "counseling" approach is much more effective.

    On the other hand, I often receive questions on how to best handle cognitive biases. So, to further help advisors deal with the complexities involved with cognitive biases, I have created two sub-categories: "belief perseverance" biases and "information processing" biases.

    The author is a freelance contributor to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.