Behavioral finance, a field that blends psychology with economic decision-making, provides profound insights into the complexities of human behavior in the financial realm. I have been interested in this topic for years, and my interest has only been enhanced since working in financial services. That is where I came to meet Dr. Daniel Crosby, Ph.D., a well-known and respected thought leader on this topic and chief behavioral officer at Orion Advisor Solutions.
I recently had the opportunity to sit down with Dr. Crosby and discuss how our minds influence financial decisions. He believes this is a fundamental element of investing that every financial advisor needs to understand better. This type of thinking influences how we think about our business and offerings at Flourish, and I know I am not alone in this, so I wanted to share highlights with the industry on what I learned from our conversation. (The following has been edited for length and clarity.)
Max Lane: Let’s start with the basics. What is behavioral finance?
Dr. Crosby: Behavioral finance acknowledges the inherent messiness of human nature. Traditional finance models assume rationality, expecting individuals to maximize utility and always act in their best interests. However, psychologists have long observed that human behavior often deviates from these rational models in predictable ways. This intersection of psychology and finance gives rise to behavioral finance, which seeks to understand and address the psychological underpinnings of financial decision-making.
ML: Why is it important for advisors to care about behavioral finance?
DC: Understanding behavioral finance can significantly enhance the value financial advisors bring to their clients. Research from Merrill Lynch highlights that the behavioral and relationship aspects of advising contribute more to client satisfaction and financial success than the technical aspects alone.
However, integrating behavioral finance into advisory practices is not a one-time effort. Clients tend to forget the majority of what they learn if it’s not reinforced and personalized. Therefore, advisors should embed behavioral finance principles throughout the entire client relationship. This involves continuous education and using technology to reinforce these concepts regularly.
For example, when dealing with clients with strong emotional ties to certain financial decisions, advisors should adopt a stance of curiosity rather than judgment. Understanding the emotional motivations behind financial choices allows advisors to provide more empathetic and practical guidance.
M: What are some of the biases of which advisors should be aware?
DC: In my book, The Behavioral Investor, I categorize the numerous cognitive biases affecting a person’s financial decisions into four broad areas, which I call “the Four Pillars of Irrationality”:
- Ego (Overconfidence): Many individuals, particularly men, tend to overestimate their abilities and knowledge. This overconfidence can lead to poor investment choices, as people believe they can predict market movements and identify winning investments more accurately than they can. Moreover, this bias can cause an underestimation of risk, exacerbating potential financial pitfalls.
- Emotion: Our brains form likes and dislikes in milliseconds, often before we are consciously aware of them. These initial emotional reactions can heavily influence financial decisions, leading to choices that feel right but are not necessarily logical or beneficial in the long run.
- Conservatism (Status Quo Bias): People tend to stick with what they know. This can manifest in various ways, such as regional biases in investment portfolios or a reluctance to sell losing investments due to a fear of realizing a loss. The pain of loss is often more acutely felt than the joy of a gain, leading to overly conservative financial behavior.
- Attention: We are naturally drawn to the sensational and the flashy. This bias means that investors often chase hot stocks or trends that receive a lot of media attention while ignoring more mundane but potentially lucrative opportunities.
M: Where does cash fit into this discussion?
DC: Cash holds a unique place in people’s financial lives, often associated with security and stability. This emotional connection can lead to overly conservative behavior, where individuals hold onto cash investments even when better alternatives exist. Advisors can help clients overcome this bias by suggesting incremental changes rather than large, overwhelming shifts. Money is rational, but it is also emotional. When advisors view cash as purely rational and skip out on the emotional component, they miss out on a valuable opportunity to deepen both the level of their advice and the relationship with the client.
M: Have you ever had a client make a questionable decision? Most advisors we work with have encountered this. So, how do you address emotional decision-making?
DC: There are times that clients make certain decisions based on emotions. Consider a scenario where a client wants to pay off their mortgage despite earning better returns on their investments. From a mathematical perspective, this might seem suboptimal. However, the advisor’s role is to understand the emotional motivations behind this decision. Perhaps the client has a deep-seated fear of debt due to past experiences.
M: We recently collected data that shows clients recognize the irrationality of holding excess cash, but the emotional benefits, such as a sense of security and control over spending, outweigh logical considerations.
DC: Advisors should assume that clients may have more cash than disclosed and create a non-judgmental space to understand their behavior. Instead of immediately attempting to change behavior, advisors should delve into the root of client decisions, fostering trust and positioning themselves as comprehensive financial support. By approaching the conversation with curiosity and empathy, advisors can better align their advice with the client’s emotional needs and financial goals.
M: So, how will “BeFi” evolve?
DC: I believe that the trajectory of behavioral finance mirrors that of psychology. Initially focused on understanding and addressing human fallibility, the field is now shifting towards exploring how financial decisions can enhance overall well-being and happiness.
Conclusion
Behavioral finance offers invaluable insights for financial advisors into the psychological factors that influence consumer financial decision-making. By integrating these principles into advisory practices, financial professionals can better serve their clients, helping them achieve financial success, personal fulfillment, and happiness.
Max Lane is CEO of Flourish.
