How advisors can help fight behavioural biases with ETFs

Prerna Mathews
Vice President, ETF Product Strategy

Investing in the financial markets can be a rewarding endeavour, but it also comes with its fair share of challenges. One of the most significant challenges an investor might face is their own human behaviour. Fear, greed and overconfidence can lead to costly mistakes and hinder long-term financial success. In this blog post, we explore the importance of advisors in coaching against behavioural biases and how different exchange-traded funds (ETFs) can help you stay invested and achieve your financial goals.

Understanding behavioural investing biases

Behavioural investing biases are the irrational decisions that investors often make due to emotional reactions rather than rational analysis. Some common biases include:

1. Loss aversion: Investors tend to feel the pain of losses more acutely than the pleasure of gains and may lead them to sell investments prematurely during market downturns.

2. Overconfidence: Many investors believe they can consistently beat the market, leading to excessive trading and poor portfolio performance.

3. Confirmation bias: Investors often seek out information that confirms their existing beliefs while ignoring contrary evidence, potentially leading to poor investment decisions.

4. Herd mentality: Following the crowd can lead to buying assets at inflated prices and selling them at a loss if the crowd panics.

Advisors can help mitigate behavioural biases in investing

Financial advisors play a crucial role in helping investors recognize and overcome these biases. Here are some ways they can help:

1. Education: Advisors can educate clients about the common behavioural biases and their potential consequences. Understanding these biases is the first step in managing them.

2. Objective perspective: Advisors can provide an objective viewpoint, helping clients make decisions based on facts rather than emotions. They can act as a buffer against impulsive actions.

3. Long term focus: Advisors emphasize the importance of a long-term investment strategy. By focusing on goals and a well-structured plan, clients are less likely to react to short-term market fluctuations.

4. Diversification: Advisors encourage diversifying portfolios with various asset classes, including ETFs, to spread risk. Diversification can reduce the impact of emotional decisions about a single investment.

Using ETFs to overcome behavioral biases

ETFs are cost-effective investment vehicles and a diversified way to invest in various asset classes, such as stocks, bonds and commodities. Here's how different ETFs can help investors achieve their financial goals while staying invested:

1. Broad market exposure: ETFs provide exposure to entire market segments, reducing the risk associated with picking individual stocks. For example, a broad market ETF can offer exposure to the entire US stock market.

2. Sector-specific ETFs: Investors can target specific sectors or industries through ETFs. This allows a strategic allocation based on market trends and individual preferences.

3. Risk management: ETFs offer a wide range of options, including low-volatility ETFs and dividend-focused ETFs, to help manage risk and generate income in a portfolio.

4. Global diversification: International and global ETFs allow investors to diversify their portfolios across borders, reducing exposure to domestic economic fluctuations.

Asset allocation ETFs: Allies in behavioural investing

Asset allocation ETFs are designed with a specific mix of asset classes, such as stocks and bonds, tailored to achieve a specific risk-return profile. Here's how these ETFs can act as effective antidotes to common behavioural biases:

1. Simplified decision-making: Asset allocation ETFs simplify the investment decision process. Instead of constantly selecting and rebalancing individual securities, investors can choose a single asset allocation ETF that aligns with their risk tolerance and investment goals. This simplicity reduces the temptation to trade frequently, based on overconfidence and the illusion of control.

2. Automated rebalancing: Maintaining a well-diversified portfolio requires regular rebalancing to ensure desired weightings. Asset allocation ETFs automatically rebalance their holdings to maintain the predetermined mix. This minimizes the impact of biases such as loss aversion, which may cause investors to hesitate or resist rebalancing during market turbulence.

3. Risk management: Asset allocation ETFs are structured to manage risk by including a mix of asset classes. For instance, a conservative asset allocation ETF might have a higher allocation to bonds, which can stabilize the portfolio during stock market downturns. This helps mitigate the behavioural bias of panic selling during market volatility.

4. Goal alignment: These ETFs are typically designed with specific investment objectives in mind, such as income or growth. By aligning the ETF's objective with their own financial goals, investors are less likely to stray from their long-term strategy due to impulsive decisions based on recency bias (placing too much importance on recent events).

5. Dollar-cost averaging: Asset allocation ETFs can be excellent choices for investors employing dollar-cost averaging (DCA), which involves regularly investing a fixed amount of money regardless of market conditions. DCA helps investors overcome the timing bias, as they consistently invest regardless of short-term market fluctuations.

6. Behavioural guardrails: Advisors can use asset allocation ETFs as behavioural guardrails for their clients. By selecting the appropriate ETF based on a client's risk tolerance and investment goals, advisors provide a structured framework that can help clients stay disciplined and avoid emotional reactions to market events.

When it comes to behavioural finance, asset allocation ETFs provide more than just diversification and performance; they can be allies against biased decision making. These ETFs provide a structured, automated and goal-oriented approach to investing that can help investors stay on course, even when heightened emotions can lead to suboptimal decisions.

In partnership with knowledgeable advisors, asset allocation ETFs empower clients to invest with confidence, discipline and resilience against the behavioural biases that might otherwise derail their long-term financial goals. By recognizing the role these ETFs can play in maintaining discipline, investors can harness their benefits to achieve their financial objectives while keeping their behavioural biases in check.

Commissions, management fees, brokerage fees and expenses all may be associated with Exchange Traded Funds. Please read the prospectus before investing. Exchange Traded Funds are not guaranteed, their values change frequently and past performance may not be repeated.

The content of this article (including facts, views, opinions, recommendations, descriptions of or references to, products or securities) is not to be used or construed as investment advice, as an offer to sell or the solicitation of an offer to buy, or an endorsement, recommendation or sponsorship of any entity or security cited. Although we endeavour to ensure its accuracy and completeness, we assume no responsibility for any reliance upon it.

This article may contain forward-looking information which reflect our or third-party current expectations or forecasts of future events. Forward-looking information is inherently subject to, among other things, risks, uncertainties and assumptions that could cause actual results to differ materially from those expressed herein. These risks, uncertainties and assumptions include, without limitation, general economic, political and market factors, interest and foreign exchange rates, the volatility of equity and capital markets, business competition, technological change, changes in government regulations, changes in tax laws, unexpected judicial or regulatory proceedings and catastrophic events. Please consider these and other factors carefully and not place undue reliance on forward-looking information. The forward-looking information contained herein is current only as of March 13, 2024. There should be no expectation that such information will in all circumstances be updated, supplemented or revised whether as a result of new information, changing circumstances, future events or otherwise.

Meet your authors

Prerna Mathews
Vice President, ETF Product Strategy

Prerna’s years of experience working across a broad spectrum of financial institutions, including RBC and Vanguard, have given her a depth of knowledge that she shares generously. She regularly mentors female financial professionals and new immigrants to help them get a better understanding of finance and investing.

Prerna’s entrepreneurial background makes her ideal for helping to create ETFs that have distinct competitive advantages. Her early experiences working in finance made her realize that Canadian investors had limited choices. She says, “I love that I’ve been able to evolve this industry and help create more options for Canadian investors, with ETFs that are built specifically for them.”