Behavioral Finance Third, we have the “illusion of control.” Investors demonstrate this by putting too little effort into planning ahead, and are overcome by surprise when their investments don’t meet their objective. We see it in the husband who won’t buy life insurance because his wife’s best policy is her own good looks. Fourth, we have “hindsight bias.” We laugh when the clueless person on the sitcom says, “I knew that.” In reality, once we learn what did happen, we look back and believe that we knew it was going to happen all along. For example: Psychologist Baruch Fischhoff ran a study on hindsight bias. Right before Nixon’s trip to China, dozens of Israeli university students were asked to predict the probability that his visit would be a success. Then, at two intervals after his trip, they were asked to recall their earlier forecasts of what would happen. The trip had as much chance of turning out a disaster as a success. In fact, it was wildly successful beyond all imagination. Less than two weeks after Nixon’s visit, 71% of the students remembered predicting a higher probability of success than they actually had. Four months after the visit, 81% claimed to have been more certain it would succeed than they really were at the time.
the traps of overconfidence. We will discuss other Behavioral Finance biases in future articles. uuu
David Williams, CFP®, Partner of Business Enhancement Associates, LLC, helps business owners and corporations grow, protect, and transfer wealth. Dave is also a Registered Investment Advisory Associate with Wealth Strategies Advisory Group, Inc. Prior to establishing his business consultancy, he was Director of Financial Planning for Regions Morgan Keegan Trust. As a CFP® since 1985, and with more than 25 years of financial planning experience working with business owners, Dave also has expertise in advanced estate and charitable planning, employer stock option planning, and qualified plans. He is a Past President of the Financial Planning Association of the Mid-South. Dave can be reached at: Dave@WSG-TN.com.
The intuitive shortcuts of heuristics and overconfidence can trip up an investor who is unaware that they exist. Such biases lead to financial mistakes such as overconcentration or failure to act. Worse, it can cause our clients to forget how they failed to follow our recommendations and wrongly give them the impression that they foreknew downturns and blame us for not acting. It is important for advisors to document their recommendations, use an Investment Policy Statement that specifies diversification, and review these documents regularly with our clients. Even more important, we must check ourselves to make sure we don’t fall into www.transitions-mag.com
Business Management for Independent FInancial Advisors