“Investments work, but investors don’t.” One way to interpret that phrase is through the lens of behavioral finance – investors don’t tend to work as well as their investments because investors often misbehave. Behavioral financial advice integrates traditional financial planning concepts – which are necessary, but not sufficient – and combines them with the psychology of money and neuroscience. The goal is to help moderate investors’ behavior, which is one of the biggest factors impacting their investing performance.
The brain is actually wired to avoid danger and pursue opportunity. For example, when we are excited, our opportunity system turns on; when we are frightened, our danger system turns on. Both systems disable our ability to think clearly, and can lead us – regardless of our intellect – to make irrational decisions. Advisors can help their clients be conscious of these systems to help them avoid making irrational decisions when investing.
Unfortunately, the financial services industry often exacerbates these irrational behavioral tendencies by selling what consumers find emotionally easy to buy. The industry takes advantage of consumers’ desires to have stuff by supplying them with high-interest credit to help fulfill those desires. As a result, consumers are buying on credit at 20- to 30-percent interest rates and finding themselves buried in debt. When it comes to investing, the industry tends to prey on greed and fear. Rationally, we know it’s better to buy low and sell high, but emotionally, we tend to do the opposite. The industry accommodates that impulse, which helps explain why investments work, but investors don’t.
Financial consultants can help support their clients by reminding them that they should strive to make rational decisions instead of emotional ones. Irrational decision-making trumps high I.Q. every time. It’s not about how smart someone is; it’s about how capable they are of accessing that intelligence in the presence of competing emotions. When advisors reinforce the importance of rational decision-making, investors are often better positioned for managing life circumstances effectively. Instead of chasing returns, they are prepared for what we call the “certainty of uncertainty.”
"When advisors reinforce the importance of rational decision-making, investors are often better positioned for managing life circumstances effectively. Instead of chasing returns, they are prepared for what we call the 'certainty of uncertainty.'"
Incorporating behavioral financial advice in their practices can also offer advisors a way to compete with “robo-advisors” – online advisors and do-it-yourself investing websites. To remain relevant in an environment in which they can compete with robo-advisors on price, advisors must help clients prepare for the uncertain and understand their own thinking.
Most importantly, behavioral financial advice allows advisors to focus on the client's performance and goals instead of on investment performance. This is where it’s important to remember that the client’s performance is not the same thing as investment performance. After all, generating a higher return is really not a personal, meaningful goal for most clients. Rather than focusing on investment performance, advisors should ask their clients: “What do you plan to use the money for?” and “When do you plan to use it?” Most people know they’ll have certain life occurrences they can plan for that will require additional money , but there are many circumstances that simply cannot be anticipated.
For example, most people know when their children are going to college, but don't know when their children will get married. We can’t predict when someone in the family will become disabled or pass away. Even retirement – which used to be something most people expected to happen around age 65 – is no longer a predictable life event. More and more people are choosing to work well past traditional retirement age, whether out of financial necessity or a desire to remain productive. Behavioral financial advice starts with teaching clients to make rational decisions about investing so they have the money to reach their goals – whether planned or unplanned.
Warren Buffet has a saying, and I paraphrase: “The markets are the world's way of transferring wealth from the irrational people to the rational.” Echoing that sentiment, behavioral finance is also about helping investors understand they have a high probability of behaving irrationally in the presence of high-energy emotions.
Emotional intelligence starts with self-awareness. Though most financial consultants have heard of self-awareness, most haven't yet applied the concept to their businesses. Taking the concept from theory into practice with clients is the difficult part.
First, it starts with the financial advisor. You can't give away that which you don't have. Advisors must first embrace the core concepts of behavioral finance for themselves before incorporating them with clients. Next, they should practice reflecting on and clarifying their personal goals, as they relate to both life and to their business.
Finally, as advisors put the concepts of behavioral finance into practice with their clients, they should be able to explain the difference between a natural response and a rational response by helping them learn how to practice paying attention to themselves Focusing on values and goals instead of performance is a good start, but advisors need to take it a step further. Values, plus goals, plus rational decisions equal results. Combining values-based financial planning with goals-based planning and behavioral finance is the key to helping clients achieve the results they need.
Investing involves risk, including possible loss of principal.
The opinions and forecasts expressed are those of the author and individuals quoted and should not be construed as a recommendation or as complete.