Interpersonal Communication in Behavioral Finance

Our decision-making process as humans is not flawless. This statement is particularly true in Behavioral Finances. The cognitive biases towards finances are imperfect and are often predicated on fear, greed, and other emotions rather than logic. Financial professionals need to understand these behaviors so they can help their clients identify and tackle their cognitive biases.

The House Money Effect is a situation commonly referenced with gambling in a casino. Suppose you won $1,000 at a blackjack table. You may be more inclined to change your risk decisions (beta) and willing to risk it all since this was money not anticipated to have. Instead of playing with “house money,” stick to the script and don’t change your risk tolerance. In this instance, it may be prudent to take a step back and look at your financial portfolio and potentially take some money (risk) off the table. Use the winnings to pay off some debt or apply more towards your savings goals.

Risk Aversion bias would be the opposite of the house money effect. Suppose you had the option of either a guaranteed winning of $1,000 immediately, or a flip of a coin for a chance to win $5,000. Some would choose the guaranteed $1,000 since the fear (risk) of losing is far greater than the chance (risk) of winning $5,000. Sometimes this bias can hinder a client from reaching their financial goals. It is important to understand the client's risk tolerance and compare that to their expectations on the return on investment (RoI).

The Sunken Cost Fallacy is analogous to the Anchoring bias. This situation is common for those who are emotionally tied to the starting point of the particular investment. Often clients may say that they “can’t sell the investment for a loss.” This thought process could lead to a slow and painful death on their investment. Instead of focusing on the loss, look at turning the loss realized into a tax hibernation strategy and offset the capital loss with other realized gains.

Familiarity bias is a behavior where people favor things that are known to them such as local sports teams, neighborhood diners, or local companies. In the financial analogy, clients tend to stick to investments that they know, are trending, or are just used to from past experiences. This bias can prevent the client from diversifying and broadening their horizons out to an unfamiliar territory where they may be an opportunity to achieve more upside on their investment returns.

For a financial planner, it is important to be aware of cognitive biases and how they affect your individual client. It is also imperative to use caution when jumping to conclusions and recommending outcomes based on their bias. Taking the time to really get to know the client will help decipher emotional biases from overall values or moral-based reasoning.