Financial decisions often stir up powerful emotions and awaken old habits. Being an effective sounding board demands technical knowledge of planning and investing, as well as an understanding of how behavioral economics can impact a client’s decision-making process.
In part one of this series, I explained the cognitive bias “anchoring” and how it can affect financial decision-making. In brief: Anchoring is a term used to describe the common tendency to rely too heavily—or “anchor”—on just one piece of information when making decisions. The bias comes into play when an individual fails to appropriately adjust to any new information because they are anchored to an original reference point.
Here, I’ll explore both optimistic and pessimistic mindsets and address how to find a balance with all clients when it comes to financial decision-making.
Pessimism and optimism in finance
A mindset can shape the way information is processed and how an individual arrives at decisions. Case in point: Look at this inkblot video. What do you see?
Anchoring influenced by optimistic or pessimistic tendencies can lead to material differences in future outcomes when it comes to investors’ portfolios and financial wellbeing. For example:
- The Optimistic Investor: Buys shares of stocks that have dropped considerably over a short period of time—hopeful and confident that things will rebound.
- The Pessimistic Investor: Receives a lump sum of new money and targets an arbitrary level in the market before investing—overthinking all the possible negative outcomes.
Both optimism and pessimism have their strengths and their flaws—especially when taken to extremes. The solution is to find the middle ground in an effort to close the behavior gap; neither of the two principles should be ignored or over-relied upon.1
Some clients are optimists. Some clients are pessimists. How do you manage both effectively?
Risk-reward matters to investors. And all investors are subject to influences on their emotions, which can then have either positive or negative implications for their investing habits. These influences are not predictors of success or failure as an investor; the outcome depends on many factors, including an investor’s level of self-awareness. A balanced decision-making framework – bringing together IQ (reason: quantitative analysis) with EQ (emotion: qualitative bias), aims to better manage human preferences, biases and behaviors
For pessimistic clients, decisions may be based more on risk than return—fear over desire. Pessimists tend to:
- Focus on negative anchors;
- Feel anxious about short-term volatility and portfolio losses;
- Communicate with their advisors more often
- Communicate more about worries and fears (versus wishes and wants)2
Understanding this trait can help an advisor be a barrier between this type of client and their tendency to focus on the possibility of the worst outcome. These three tactics can help improve the decision-making process:
- Focus on goals: By connecting investment decisions with personal goals, we can redirect the pessimistic investor’s tendency to be influenced by anchoring bias during down markets—when they’re most vulnerable to making emotionally charged decisions.
- Balance risk: Pessimistic investors are prone to excessive risk avoidance; that can mean too much opportunity risk and underachieving long-term goals. Illustrating best- and worst-case scenarios for both too much and too little risk can help these clients strike a balance. Highlight the benefits of diversification in lowering overall portfolio risk.
- Structure decisions: Fear of uncertainty often leads these clients to second-guess or ruminate on decisions. Provide a structured decision-making process that focuses on the decision and information at hand and remind these clients that their goal is to arrive at a good decision, not the perfect decision.
For optimistic clients, decisions are often based on a belief in a better future—less likely to be controlled by the recency effect.3 Optimistic investors tend to:
- Focus on positive anchors;
- Be more accepting of portfolio fluctuations;
- Be wooed more by riskier options;
- Become demotivated when they don’t achieve goals.4
While optimistic clients are often less demanding than pessimistic clients, they also benefit from an advisor acting as a buffer between themselves and their tendency to harbor a starry-eyed view of the future. With guidance, advisors can shift an optimist’s focus away from the future and back towards the present:
- Stay on target: Linking the financial plan with personal goals can apply the guardrails necessary to ensure that an optimistic outlook doesn’t lead to overconfidence. Staying on track and experiencing the positive aspects of making prudent decisions is a powerful incentive to avoid spending beyond one’s means or investing like a bull market will never end.
- Tolerance and capacity for risk: For clients who may take on excessive risk with the expectation of higher returns, help them to align their risk level with their financial goals, determining how much risk they can reasonably afford to take. Explain that higher risk does not always lead to higher returns; use illustrative concepts, such as sequence of returns.
- Balanced thinking: Rose-colored glasses can have negative consequences. While it's good for investors to see the positive in situations, not acknowledging the negative can be a hindrance in the long run. The optimistic investor is ready to learn from mistakes. Build on this quality with co-planning techniques and hands-on experiential learning to train their brain to be a constructive optimist.5
Optimism and pessimism are strong, stable traits that reflect our coping strategies
It is important to note that where an individual falls on the optimism-pessimism spectrum does not equate to being a “good” or “bad” investor (or client). And while an optimistic mindset in decision-making is often an asset, it’s vital to recognize the potential of a pessimistic mindset. Despite having a negative connotation, pessimism can be healthy and is often a valuable perspective. The key, however, is to find purpose in the choice and connect that to the financial life—the intersection between the things that matter and the things we can control.
Coaching clients to find a balance between healthy amounts of both optimism and pessimism may be challenging, but providing the right level of support can help clients become more self-aware of their behavior and subconscious tendencies, and improve their financial decision-making.
1Corporate Finance Institute© (CFI) Trading & Investing Guides, “Pessimist vs Optimist Investors.”
2State Street Global Advisors, Cognitive Bias Investor Survey, January 2019.
3“Recency Effect” is a psychological term that states that the most recent experiences we go through are the ones that we remember best and receives greater weight in forming a judgement.
4State Street Global Advisors, Cognitive Bias Investor Survey, January 2019.
5Amy Morin, Psychotherapist and mental strength author, “5 Ways An Overly Optimistic Outlook Can Hold You Back from Success,” Forbes article, March 11, 2015.