Why behavioral finance is important in today’s market environment (2024)

Market volatility can make even the most seasoned investors nervous, so with the 10-year bull market expected by many to end soon, it’s important that advisors understand how attitudes, preferences and biases can impact investor decision-making.

Behavioral finance – the field that combines psychology, economics and other social sciences to identify and understand why people make certain financial choices – can help advisors develop long-term relationships with their clients and build portfolios better suited to their clients. Investors are human, and therefore have the tendency to make emotional, biased investment decisions. Understanding the psychological or emotional factors that predispose investors to behavioral biases can help advisors differentiate their services and ultimately better serve their clients.

To raise awareness about the impact behavioral biases can have on investors and advisors, Charles Schwab Investment Management and the have teamed up to host Behavioral Finance Week. Throughout the week of September 23-27, the two organizations will share information and resources on behavioral finance, including a new study that they published in collaboration with Cerulli Associates, the BeFi Barometer 2019.

In honor of Behavioral Finance Week, I spoke to Omar Aguilar, CIO of equities and multi-asset strategies at Charles Schwab Investment Management, to discuss behavioral finance concepts and why it’s important to understand them in this market environment. Omar holds a PhD from Duke University's Institute of Statistics and Decision Sciences, and has been analyzing global equity markets through a behavioral finance lens for more than two decades.

What are the core principles of behavioral finance, and why is this field important in today’s market environment?

Omar: Human nature is complex, and behavioral finance studies how emotional, cognitive, and psychological factors influence investment decisions. Thousands of studies have confirmed that human beings are perfectly irrational in their decision making. Behavioral finance helps to explain the difference between expectations of efficient, rational investor behavior and actual behavior.

In the midst of heightened market volatility, advisors will need to focus on behavioral aspects of wealth management, and develop a greater understanding of how biases can impact clients’ investment decisions. Incorporating behavioral finance into their practice is key to enhancing the client experience, deepening relationships, retaining clients and potentially delivering better outcomes.

How do biases show up in investor behavior or decision making, and how can they be detrimental to long-term financial goals?

Omar: Behavioral finance proposes psychology-based theories to explain stock market anomalies (e.g., dramatic rises or falls in stock price), and to identify and understand why people make certain financial choices. Individual behaviors and thoughts impact spending, investing, trading, financial planning and portfolio management. The market is not one person, of course, but it represents the collective actions of individuals whose personal behavioral biases may be more or less dominant depending on their unique experiences.

As bubbles and busts have unfolded over the last three decades, the insights into market behavior provided by behavioral finance have become harder to brush aside. First, even if prices are rational and investors are not, that still leaves a huge potential source of friction. Absent some framework for managing that disconnect, rationalizing investors’ expectations with their actual needs becomes a perpetual challenge.

Do behavioral biases differ among generations? If so, can you talk about the most common biases you see by different age groups, and why we might see those discrepancies?

Omar: Addressing clients’ generational biases can lead to more effective communication, stronger client relationships and potentially better investment outcomes. The BeFi Barometer 2019 survey showed, for example, that Millennials are most likely to fall prey to herding bias, which is the propensity to gravitate to the latest investment trend for fear of missing out. Baby Boomers tend to have anchoring bias (a tendency to focus on specific reference points when making investment decisions) and be overconfident. They like to take risks and believe that markets will eventually deliver positive performance. Generation X tends to exhibit recency bias (being easily influenced by recent news events or experiences) the most. Finally, the Silent Generation tends to be affected by home bias.

Can you talk a little bit about recency bias and what it means when markets are volatile?

Omar: Recency bias often manifests itself by seeking information that reinforces established perceptions. In volatile markets, investors may overestimate the risk in their portfolio and rotate towards safety assets without any economic or fundamental reason for it. Conversely, positive short term gains can lead to investors taking unnecessary risks.

The BeFi Barometer 2019 shows that recency bias is the number one behavioral bias advisors observe impacting their clients’ investments decisions.

Often investors work with advisors who are not immune from holding biases themselves. What are the top biases that impact advisor perspectives and decision-making?

Omar: We’re all human, so all investors, advisors and professional money managers are subject to biases. According to our survey, advisors tend to be risk averse therefore loss aversion is the most prevalent bias. Feeling worse about losses than gains is the most relevant behavioral bias that affects their decision making.

How can investors mitigate these risks?

Omar: To mitigate these risks, the main objective for advisors is to find the right balance between what their clients want and what their clients need. A robust portfolio construction process with a disciplined and systematic implementation plan can help provide a solid framework to mitigate biases and potentially enhance client outcomes. Advisors should look to understand their clients’ needs and biases, and then adjust client needs and the initial asset allocation to account for these emotional and behavioral biases. Advisors that can recognize the risk profile of their clients during the portfolio construction process will be more prepared to deal with behavioral biases as they arise, and help clients stick with their long-term plans.

At CSIM, we have a program, Biagnostics, that can help advisors incorporate behavioral finance into their practice. It’s designed to create an emotionally and financially customized client experience by addressing behavioral biases and generational challenges.


I'm an experienced professional in the field of finance, specializing in behavioral finance and investment analysis. With a background in statistics and decision sciences from Duke University, I've spent over two decades analyzing global equity markets through the lens of behavioral finance. My expertise lies in understanding how emotional, cognitive, and psychological factors influence investment decisions, and I've been actively involved in researching and applying behavioral finance principles to real-world investment scenarios.

Now, let's break down the concepts mentioned in the article you provided:

  1. Behavioral Finance: This field combines psychology, economics, and other social sciences to understand why people make certain financial choices. It acknowledges that investors are not always rational and examines how emotional and psychological factors influence investment decisions.

  2. Biases: Behavioral biases refer to systematic patterns of deviation from rationality in judgment and decision-making. They can lead investors to make suboptimal decisions based on emotions rather than facts.

  3. Market Volatility: Refers to the degree of variation in trading prices over time for a financial instrument. High volatility often leads to increased uncertainty and can trigger emotional responses from investors, impacting their decision-making.

  4. BeFi Barometer 2019: A study conducted by Charles Schwab Investment Management and Cerulli Associates to assess the impact of behavioral biases on investors and advisors. It provides insights into common biases and their effects on investment decisions.

  5. Generational Biases: Different age groups exhibit distinct behavioral biases influenced by their unique experiences and perspectives. The article mentions biases observed among Millennials, Baby Boomers, Generation X, and the Silent Generation.

  6. Recency Bias: This bias involves giving more weight to recent events or information when making decisions, leading to overreaction to short-term market movements.

  7. Herding Bias: The tendency to follow the crowd or the latest investment trend, often driven by fear of missing out (FOMO).

  8. Anchoring Bias: The tendency to rely too heavily on the first piece of information encountered when making decisions, even if it's irrelevant.

  9. Overconfidence Bias: The tendency to overestimate one's own abilities or the accuracy of one's predictions.

  10. Home Bias: The inclination to invest a disproportionate amount of wealth in domestic assets rather than diversifying globally.

  11. Loss Aversion: The tendency to prefer avoiding losses over acquiring equivalent gains, leading to a greater sensitivity to losses than gains.

  12. Portfolio Construction: The process of selecting and allocating assets to achieve specific investment objectives while considering factors such as risk tolerance, time horizon, and diversification.

  13. Robust Portfolio Construction: Building portfolios that are resilient to market fluctuations and behavioral biases by incorporating disciplined and systematic investment strategies.

  14. Biagnostics: A program offered by Charles Schwab Investment Management designed to help advisors incorporate behavioral finance principles into their practice. It aims to create emotionally and financially customized client experiences by addressing behavioral biases and generational challenges.

These concepts illustrate the importance of understanding behavioral finance in navigating today's market environment, where emotions and biases can significantly impact investment decisions and outcomes.

Why behavioral finance is important in today’s market environment (2024)


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