Ensombl ALPD, your questions answered: Overcoming Behavioural Biases with Goals-Based Investing

Investing is not just about numbers; it’s about people. The decisions investors make are often influenced by emotional and cognitive biases, which can significantly impact financial outcomes. From the fear of loss to the allure of short-term gains, these biases create obstacles that hinder investors from achieving their long-term goals. Goals-based investing offers a practical approach to working with, rather than against, these behavioural tendencies.

Understanding behavioural Biases in Investing

Behavioural biases are mental shortcuts that simplify decision-making but can often lead us astray. If you’re looking to dive deeper into the psychology of behavioural biases, here are some highly recommended books:

1. Thinking, Fast and Slow by Daniel Kahneman – A foundational exploration of how two systems of thinking (fast and intuitive versus slow and deliberate) shape our decisions.

2. Predictably Irrational by Dan Ariely – An engaging look at the hidden forces that drive seemingly illogical human behaviour in economic and financial contexts.

3. Nudge by Richard H. Thaler and Cass R. Sunstein – A brilliant guide to how small changes in choice architecture can lead to better decision-making.

4. Misbehaving: The Making of behavioural Economics by Richard H. Thaler – A fascinating account of how behavioural economics reshaped our understanding of rationality.

5. The Little Book of Behavioural Investing by James Montier – A concise and practical guide to avoiding behavioural pitfalls in investing.

These resources provide valuable insights into why people act the way they do and how advisers can use this knowledge to help clients make better financial decisions.

Goals-Based Investing: A behavioural Solution

Goals-based investing is an innovative framework that helps advisers align investment strategies with their clients’ cash flow needs, it is simply matching investors assets with their liabilities. At its core, this approach divides wealth into distinct “buckets,” each tied to specific goals with varying levels of priority, risk tolerance, and time horizons. This structure resonates with clients because it reflects the natural way people mentally organise their finances.

For instance:

• Short-Term Bucket (Cash/Safety): Covers immediate needs, such as emergency funds or essential retirement expenses. This low-risk allocation helps clients feel secure.
• Medium-Term Bucket (Lifestyle): Addresses discretionary goals, such as travel or home renovations, blending growth and safety.
• Long-Term Bucket (Future): Focuses on aspirational or legacy goals, taking on higher risk for greater potential rewards.

By linking investments to tangible objectives, this method reduces the emotional impact of market volatility. Clients are less likely to panic-sell when they see that their “safety bucket” remains intact, even during a downturn.

Practical Strategies for Advisers

When it comes to understanding behavioural biases and implementing a goals-based investment approach, the heavy lifting happens as part of the strategic advice process. Here are some practical strategies for Advisers who wish to implement a behavioural/goals-based investing approach within their advice process.

1. Identify Biases Early: behavioural biases often surface in the language and stories clients share during their initial meetings. Use open-ended questions to encourage clients to reflect on their financial history and emotional responses to past events. For example:

• “How did you feel during the last major market downturn?”
• “Can you tell me about a financial decision you’re particularly proud of—or one you wish you could redo?”

These questions can help uncover biases like loss aversion or overconfidence.

2. Use Scenario-Based Conversations: Present hypothetical scenarios that are meaningful to your client’s financial situation to identify potential biases in how they approach risk and decision-making. For example:

• “How would you feel if you lost $50,000 on your initial $500,000 investment over the course of a year?”
• “If you were given $20,000 today, how would you decide to use it?”

3. Analyse Reactions to Historical Market Events: Ask clients how they reacted to major market events, such as the Global Financial Crisis or the COVID-19 crash. Understanding their emotional and financial responses during these periods can highlight patterns like overconfidence, the bandwagon effect, or loss aversion.

4. Observe Subtle Cues: Pay attention to the client’s body language and tone when discussing topics like volatility, risk, or past investments. Hesitation or discomfort may indicate underlying biases that they are reluctant to express directly.

5. Frame Risk in Relatable Terms: Discuss risk not as an abstract number or percentage but in terms of tangible outcomes related to their goals. Risk conversations should incorporate not only risk tolerance, but risk capacity and the client’s need to take on risk to achieve their goals. For example:

• ” If we invest some of your retirement savings more conservatively, this gives you a safety net if markets are down, and allows us to invest the rest of your wealth more aggressively to ensure we can comfortably fund your retirement over the long term.”
• “Based on our modelling, you can easily achieve your retirement goals with your current spending needs and retirement savings, so we need to discuss the trade-off between maximising your legacy goal or experiencing less potential loss on your investments and what is more important to you.”

6. Normalise Biases: Reassure clients that everyone has biases—it’s part of being human. Normalising biases can make clients more open to discussing them. You might say:

•”Many people feel uncertain about making big investment decisions. Let’s work together to create a plan that feels right for you.”

7. Encourage Incremental Change: For clients resistant to risk or change, suggest small adjustments, or making incremental investments into a portfolio over time, rather than large portfolio shifts at once. This builds confidence over time.

8. Incorporate Tools and Visual Aids: Use questionnaires, visualisation tools, or Schwartz’s values framework to guide conversations. Tools that visually show how biases like loss aversion might impact long-term goals can be particularly effective. For example, illustrating how avoiding risk might jeopardise future retirement plans helps bridge the gap between emotion and logic.

9. Encourage Clients to Reflect on Values: behavioural biases are often linked to deeper personal values. By helping clients articulate what’s most important to them—security, legacy, freedom—you can uncover the motivations driving their decisions. Open-ended questions like:

• “What does financial security mean to you?”
• “How would you like to be remembered financially by your family?” can reveal the biases influencing their choices.

10. Document and Revisit: Document the biases and concerns that surface during initial conversations and revisit them in subsequent meetings. Tracking changes in client behaviour over time can help reinforce progress and build trust.

Goals-Based Investing: A Win-Win Approach

By aligning investments with client goals, advisers can build portfolios that not only perform but also resonate emotionally. This alignment enhances client trust, reduces the likelihood of value-destructive behaviours, and ultimately improves financial outcomes. Goals-based investing isn’t just about numbers; it’s about helping clients see their future clearly and stay on the path to achieving it.

Innova Asset Management have designed a goals-based advice framework and goal simulator application to assist Advisers with implementing this approach. Contact Neil (npattinson@innovaam.com.au) or John (jli@innovaam.com.au) to request a demo of this tool.